Introduction: Let’s understand the compound interest concept by going back to school days. The compound interest means – not only an investor earns interest on the principal but also interest over interest. On the other hand, simple interest means an investor earn interest only, not interest over interest. This compound interest over a long period takes a shape of a large corpus.
To illustrate, Vijay places a lump sum amount of INR 100,000/- with a bank @6% per annum compounded annually for a period of 5-year
First year interest earning would be at INR 6,000/-; 2nd year INR 6,360/-; 3rd year INR 6,742/-; 4th year INR 7,146/-; 5th year INR 7,575/- totalling to INR 33,823/-. Under simple interest formula, the interest earned would have been INR 30,000/- only. Therefore, the difference of INR 3,823/- is the additional interest earned, which is compounding benefit. When amount is invested regularly, the power of compounding could be realised, as earnings gets compounded for meeting long-term financial goals.
Benefits of Compound Interest
Time is the essence of the power of compounding. With time, one could generate higher returns, and compounding these returns would maximise it. This would help grow investments. Therefore, saving funds regularly and investing them judiciously, to earn compounding benefit every year is the popular route.
It's not necessary to have ample funds to begin investing. Instead, one could commence investing early, irrespective of the investment amount. Even with a small amount regularly invested, one could build a significant corpus over the long-term.
Assume an investment of INR 1,000/- every month for a longer period of 35 years, generating an average return of 10% per annum. The following table would depict the growth in value at every 5-year intervals.
Particulars/ Period in years | 5 | 10 | 15 | 20 | 25 | 30 | 35 | |
Invested Amount (INR in lakh) | 0.60 | 1.20 | 1.80 | 2.40 | 3.00 | 3.60 | 4.20 | |
Likely amount receivable (INR in lakh) | 0.78 | 2.06 | 4.18 | 7.66 | 13.38 | 22.80 | 38.30 | |
Returns growth (INR in lakh) | 0.18 | 0.86 | 2.38 | 5.26 | 10.38 | 19.20 | 34.10 | |
On perusal of table contents, one could make out the real power of compounding benefit when regular investing is undertaken. The returns’ growth is exponential, that becomes a learning - how to invest for beginners.
Real Power of Compounding and Mutual Funds
Let’s talk about what comes to mind when we regularly invest a small amount? The obvious choice is Mutual Funds and that, too, SIP route. Mutual Funds are designed as an investment avenue to magnify the power of compounding. A fixed amount is invested regularly on a pre-determined date at monthly, quarterly or half-yearly intervals through Systematic Investment Plan. One could select a fund of one’s choice or take an investment advice from a Financial or Investment expert.
One may consider investing in equity funds through SIP route to attain long-term financial goals like purchasing a house/flat/apt or building retirement corpus, among others. Though returns are not guaranteed in Mutual Funds, Equity Funds have the potential to generate higher returns over the long-term. The Banks accept standing instructions from its customers for automatic debit of SIP amounts from Savings account.
Conclusion
* The biggest takeaway is to invest early when you start earning. While doing this regularly for a long-term, the returns could be higher due to the power of compounding.
* To meet one’s financial goals, it’s essential to maintain an investment discipline to build a sizable corpus for every goal.
* A bigger corpus could be accumulated when expenses are controlled. Investment amount, as percentage of income earned, must be kept aside to inculcate savings habit.
* To overcome intermittent volatility in equity markets, SIP is the best route for investing to derive optimum benefit of cost of averaging, as higher number of MF units would get allocated during correction phase.
P.S. This article may not be construed as investment advice. Please consult Financial Advisor before making any investment decision.
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