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Compounding is simply the interest earned on interest. This earning on the interest leads to substantial growth in investments and savings. You can begin investing with a very small amount as well because the important thing is not the initial investment amount but rather the duration for which you are investing.

  1. What is Compounding Interest?
  2. Compounding in Mutual Funds
  3. Key rules of Investment that give you the Benefit of Compounding
  4. How can I know how much I should Invest?

 

1. What is Compounding Interest?

The key aspect of compounding is that it generates earnings on the previous earnings along with the base capital. The point is to build a large base which keeps on adding on to the earnings. If you have INR 1 lakh invested as an initial investment which is compounded at 10 percent per annum for the following 15 years, you will have a base of INR 417,725. This is how compounding creates a cycle of earnings that keep growing.

 

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As an investor, keep in mind that the pivotal point of compounding is that the earnings generated by the investment be reinvested. One must not at any point withdraw or take the returns. This withdrawing of earnings will not let the base of the investment to grow.

2. Compounding in Mutual Funds

Mutual funds are designed are in such a manner that they harness the power of compounding. As an investor, you will make gains when the value of each unit of investment unit goes up. When you make investments over a long period of time, the benefit of compounding helps you grow your investment. This is particularly the case in mutual funds because the money that is generated in the form of capital gains further starts to create returns. You may choose to invest INR 1000 every month in a mutual fund for the next 10 years and at a rate of 8 percent per annum, you will see a sum of INR 1,63,920. So, if you notice, your investment of INR 1,20,000 in 10 years’ time gave you a return of INR 1,63,920. Now if you choose to invest it further for say another 10 years, the money now reinvested will grow even faster and give you INR 4,46,589. This is the special thing about compounding where the existing investment, along with the returns on this investment and the new investment each month, all contribute towards further gains.

Example:

Power of compounding on investment of ₹1 lakh a year for 5 years
Year Opening balance (₹) Investment (₹) 10% interest (₹) Closing balanced (₹)
1 1,00,000 10,000 1,10,000
2 1,10,000 1,00,000 21,000 2,31,000
3 2,31,000 1,00,000 33,100 3,64,100
4 3,64,100 1,00,000 46,400 5,10,500
5 5,10,500 1,00,000 61,000 6,71,500
Total investment: ₹5,00,000 | Value after 5 years: ₹6,71,500 | Interest earned: ₹1,71,500

If there was no compound interest, your total investment of ₹5 lakh would have earned you ₹50,000 at 10% interest. The difference made by compounding is worth ₹1,71,500 in the above example. That’s almost 3.43 times more than you have earned.

 
Compounding fund

3. Key rules of Investment that give you the benefit of compounding

a. Make an early start

Nothing like starting early to make the most of compounding. If you start investing from the time you start earning, it will make for a solid base that will enable your funds to grow further over the course of time.

b. Discipline

If you wish to create a healthy portfolio, it is imperative that you define your priorities and be regular in your investments. Regardless of how less you earn, knowing what your priority is and understanding how being disciplined now would pay off later, will help you develop the habit to keep funds aside for investing.

c. Be patient

A lot of us wish for quick returns not realizing that it is the long-term investments that really powerfully reap from the concept of compounding. You will have to allow your investment to grow at its own pace without meddling with it. Years of dedicated investment on your part will render a strong and healthy lump sum amount for you at the end.

d. Check your spending

Saving is a habit that all of us must inculcate but more important than that is knowing where to spend your money. It is not a difficult chore to develop a plan and then focus on it. Budgeting is important to ensure that you are never caught off guard and that you have the means to fend for yourself. If you spend wisely, you will reap well.

Example:

If you begin investing ₹1 lakh a year & increase your investment by 10% every year, this is how compounding interest will help your money grow
Year Opening balance (₹) Investment (₹) 10% Interest (₹) Closing balance (₹)
1 1,00,000 10,000 1,10,000
2 1,10,000 1,10,000 22,000 2,42,000
3 2,42,000 1,21,000 36,300 3,99,300
4 3,99,300 1,33,100 53,240 5,85,640
5 5,85,640 1,46,410 73,205 8,05,255
Total investment: ₹6,10,510 | Value after 5 years: ₹8,05,255 | Interest earned: ₹1,94,745

 
Compounding fund

4. How can I know how much I should Invest?

 

There are calculators available online where you can easily evaluate how much money you would require saving if you wish to reach a certain target. The tools available online give you the specific figures based on how much time you want to compound for, the rate of interest offered, etc.     

To know more about where you can invest to meet your financial goals, visit ClearTax and choose from our select offerings of funds.

 

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