Compound interest or compounding refers to the interest earned on interest, in addition to the principal amount. When you earn interest that interest itself starts earning interest – this is called compounding. The power of compounding lies in the fact that it generates returns at an exponential rate over longer periods of time.
Understanding compounding
Let’s understand this with a simple example. Suppose you invest Rs.10000 at 10% annual interest rate for 5 years. With simple interest, you would earn Rs.10000 * 10% * 5 = Rs.5000 per year. Your total returns would be Rs.5000 * 5 = Rs.25,000. However, with compound interest, in the first year you will earn Rs.10000 * 10% = Rs.1000. In the second year, your principal is now Rs.10000 + Rs.1000 = Rs.11,000. You will earn 10% of Rs.11,000 which is Rs.1100. This keeps building up every year. After 5 years, your total returns with compound interest works out to Rs.31,200.
You can see how compounding has a significant multiplying effect on returns over time compared to simple interest. This phenomenon is known as the ‘eighth wonder of the world’ by Albert Einstein.
Use a compound interest calculator wisely
There are many free online compound interest calculators available that can help you estimate future values based on your investment amounts, interest rates and time periods. It is a good idea to use such a calculator to get a basic sense of how compounding can impact your wealth over long durations. However, when relying on calculators, keep the following points in mind.
– Interest rates used are assumed to remain constant over time. In reality, they will fluctuate.
– Inflation is not factored in. Calculated future values will be in terms of today’s prices.
– Tax implications and other charges are not considered.
– Withdrawals or partial redemptions are not accounted for.
So while compound interest calculator give a broad idea, don’t assume the results will exactly match your real returns. Actual results will vary based on changing market conditions.
Mutual funds – Harness the power of compounding efficiently
One of the most efficient ways to benefit from compounding is by investing in mutual funds. When you invest in a mutual fund, your money is pooled with that of other investors. The pooled amount is then invested by professional fund managers in stocks, bonds and other securities. As the value of underlying investments grows over time, so does the value of your mutual fund units.
Some key advantages mutual funds offer for harnessing compounding are –
– Diversification: Mutual funds invest in a basket of securities spread across sectors and companies. This diversification reduces risk compared to investing in individual stocks.
– Professional management: Full-time fund managers research companies and allocate your money where it can yield higher long-term returns. You can benefit from their expertise.
– Low minimum investment: Many funds now allow you to start with as low as Rs. 500 per month. This makes compounding more accessible.
– Reinvestment of earnings: Dividends and capital gains are automatically re-invested to buy additional units, facilitating the power of compounding.
– Convenience: Once you start an SIP, subsequent investments are auto-debited every month from your bank account. You don’t need to keep investing manually.
Conclusion
The exponential effect of compound interest over longer periods cannot be stressed enough. Starting early with small, disciplined investments and allowing the power of compounding to work is crucial for building significant long-term wealth. Mutual funds are an ideal way to participate in the equity markets and benefit from compounding with ease and diversification. While past returns may not be indicative of future performance, with patience and persistence, mutual funds can unlock the vast potential of compounding to help achieve your financial goals.
