What is the Power of Compounding?
Aashish, a young professional, asks his father, an avid trader with Angel One, what the power of compounding is all about. His father explains:
Through the power of compounding, a small amount of money can grow into a substantial sum over a period. The longer the timeframe, the greater the value. For example, in order to achieve your future financial goal, you invest 1 lakh rupees per annum in a bank fixed deposit for 30 years at 5.5% interest rate (post-tax effective rate), your savings will grow to 76.4 lakh rupees, which is two and a half times the amount you invested.
Equities, however, have historically outperformed other asset classes. They yield approximate returns of 16 per cent over a longer period. If you invest the same amount for the same period in equities rather than a bank fixed deposit (assuming you get 14 per cent interest), your savings will grow to 4.1 crore rupees. This value is more than thirteen and a half times the amount you invested. Thanks to his father, Ashish now understands the power of compounding.
Formula for Compounding
The formula for calculating compound interest(CI) is as follows:
CI = P (1 + r / 100) n – P
Here,
P = Principal amount,
r = Rate of interest,
and n = number of years.
To calculate the amount of compound interest, we simply put the corresponding values into the formula. However, with the advent of online calculators, we no longer need to calculate the formula manually.
Example of Compounding
Mr X has invested in an asset of ₹10,000 for 10 years that yields:
Case 1: Simple interest of 7%
At the end of the tenure, Mr X will have earned a total interest of ₹7,000.
Case 2: Compound interest of 7%
The total interest earned by Mr X will amount to ₹20,097.
Check out how compounding can level up your investments with Angel One’s Compound Interest Calculator.
How Does the Compounding Work in a Fixed Deposit?
Fixed deposits (FDS) have been one of the prominent avenues of savings as they provide returns with comparatively lower risk. Fixed deposits offer savings with two types of interest rate calculations: simple interest and compound interest.
The FDs applying simple interest rates do not add interest to the principal amount. Instead, it is paid to the investor monthly, quarterly, semi-annually or annually. These are also called non-cumulative fixed deposits. It can be opted by investors who prefer stable returns over capital appreciation.
On the other hand, FDs with compound interest apply the compounding method that can help your funds grow more quickly. The interest earned in this type of FD is paid back to the account holder on the maturity date. Such FDs are also called cumulative fixed deposits. This type of FD can help maximise your earnings over a long period of time. Investors planning for their retirement who have a lower risk appetite can choose this avenue of investment.
It is important to note that a longer investment tenure can provide higher returns for compounding. As we saw in the example above, the difference between interest for 10 years comes to ₹13,097. For the same principle and interest rate but the investment period being 5 years, the difference comes down to ₹10,526.
What Is the Power of Compounding in Mutual Funds?
Investing in mutual funds can be done using a lump sum deposit or a series of periodic contributions through Systematic Investment Plans (SIPs). Choosing the latter option can help the investor benefit from compounding at a fraction of the investment cost. The contributions can be made monthly, quarterly as well as semi-annually.
Mutual funds apply the principle of compounding, resulting in returns based on capital appreciation. Over a period of time, funds invested in mutual fund schemes can accumulate to a significant corpus.
Let us understand the power of compounding in mutual funds when investing through SIPs:
Assuming Mr A invested in a mutual fund with a monthly SIP of ₹2,000, returns being 7% for a period of 10 years.
At the end of the term, his investments would have amassed to ₹2,40,000 with the total returns amounting to ₹ 1,08,189.
Now let’s assume that the SIP amount is increased by ₹3,000 (New SIP= ₹5,000). For the same return percentage and tenure, the new sum at maturity would amount to ₹8,70,472 with the returns amounting to ₹ 2,70,472.
Looking at the difference between the two scenarios, the effect of compounding can be understood. With disciplined investing, SIPs can yield returns to help you meet your dreams. This is the power of compounding in mutual funds.
What Are the Advantages of Compound Interest?
There are several advantages pertaining to compounding interest that can significantly improve your financial situation in a longer tenure. The following are the key points to consider:
- Enables you to earn interest on the principal amount as well as the interest.
- Has the potential to to generate exponential growth over time.
- Can generate wealth even over seemingly small amounts of contributions. (As we saw in the example of Mr A)
- Compounding yields increased returns over time. Even a moderate interest rate can snowball to generate returns significantly exceeding the initial interest rate.
- Investing for compounding securities can be one of the most low-maintenance approaches to generating wealth. Compound interest works in the background as you focus on other aspects of your life.
Strategies for Maximising the Power of Compounding
Some key notes that can help you unlock the max potential of compounding:
- Early investment: As mentioned earlier, compounding can significantly build your wealth over time. When you invest early, your money benefits more as it goes through more compounding cycles.
- Consistency: Investing regularly not only builds financial discipline, but investing periodically can help you take advantage of rupee cost averaging over time.
- Patience: Once you have invested, let compounding run its course. Do not change your action or pull out your investments based on short-term market fluctuations.
- Consider Tax: Taxation implications can have a huge impact on your returns. Therefore, before investing, choose after analysing how your returns will be affected by tax.
Conclusion
The power of compounding is a potent force that can significantly enhance your investments over time. By reinvesting the interest earned on your principal amount, you can experience exponential growth in your wealth, especially with disciplined and consistent investing strategies like SIPs in mutual funds or fixed deposits applying compound interest.
FAQs
How Does Compounding Work?
Compounding works by adding the interest earned on an investment back to the principal amount, allowing for exponential growth as subsequent interest calculations are based on the new, higher principal amount.
Is Compounding Suitable for Short-Term Investments?
Compounding is most effective and yields significant results over long periods. While it can technically work for short-term investments, the impact may not be as pronounced due to shorter compounding periods.
What Impact Does the Frequency of Compounding Have on Returns?
The frequency of compounding, such as annual, quarterly, or monthly, can affect overall returns. More frequent compounding intervals can lead to slightly higher returns due to the more frequent reinvestment of earnings.
