Imagine you have 10 currency notes. You take these notes and keep them away in a drawer. You don’t take the notes out of the drawer for a couple of years. Later on, when you open the drawer, there are more notes than you originally put there. You got more money by simply not touching the money you already had. This is called a fairy tale in real life. But in the world of mutual fund investments, it is called compounding interest.
Compounding interest is earning an interest on the interest you have already earned. When you invest in a mutual fund, you earn a certain percentage of returns. These returns are added to your existing investments and they earn returns as well. Simply put, if you invest ₹100 and earn an interest of ₹10, then your total corpus becomes ₹110. The next time you earn an interest, it will be on ₹110. This is how compounding interest works. It rewards you for staying invested and continuing investing.
Let’s say you invest ₹1 lakh every year in a mutual fund. For the sake of simplicity, we assume that the fund returns 10% every year. The following table shows how compounding interest would make your investments grow over 5 years.
|Power of compounding on investment of ₹1 lakh a year for 5 years|
|Year||Opening balance (₹)||Investment (₹)||10% interest (₹)||Closing balanced (₹)|
|Total investment:₹5,00,000 | Value after 5 years: ₹6,71,500 | Interest earned: ₹1,71,500|
If there was no compounding interest, your total investment of ₹5 lakh would have earned you ₹50,000 at 10% interest. The difference made by compounding is worth ₹1,21,500 in the above example. That’s almost 2.5 times more that you have earned.
The power of compounding works even better when you increase the quantum of investment every year. Increasing investments on an annual basis is a recommended way of building wealth for the long-term. As you grow older and your experience increases, your income will also rise. And with it, your investments should go up as well. It will make compounding interest even more effective.
|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 (₹)|
|Total investment: ₹6,10,510 | Value after 5 years: ₹8,05,255 | Interest earned: ₹1,94,745|
Again, the effect of compounding is huge, especially when you increase the investment amount every year. The more you increase your investment amount, the more effective compounding interest becomes.
|If you begin investing with ₹1 lakh in the first year & increase the quantum of investment every year, this is how compounding interest will help your money grow|
|Yearly increase in investment (%)||Total investment after 5 years (₹)||Value after 5 years (₹)||Interest earned (₹)|
Rate of interest is taken as 10%
All of these numbers look impressive even when the rate of interest earned has been assumed to be a conservative 10%. Equity mutual funds earn a lot more than that over the long-term. Hence, the lesson to learn here is that to create real wealth, you should stay invested in mutual funds, increase the investment amount as you can and let compounding interest work its magic for you.