What is Compound Interest in Investing
Mitali Dhoke
Aug 13, 2024 / Reading Time: Approx. 10 mins
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In recent months, the financial markets have witnessed significant turbulence, driven by factors such as geopolitical tensions, inflationary pressures, and changes in monetary policies. Amid this uncertainty, investors are increasingly seeking ways to safeguard and grow their wealth over time.
The concept of compound interest remains a steadfast and reliable principle for growing wealth, in the ever-evolving financial markets, where volatility and unpredictability are the norm.
Mutual funds, in particular, have garnered attention as they offer a diversified investment option that may mitigate risks while still providing the potential for attractive returns. In this context, the role of compound interest becomes even more pronounced, as it allows investments to grow exponentially, turning small contributions into substantial sums over the years.
[Read: Boost Your Financial Savings in 2024: A Guide to Building Wealth]
Moreover, with the mutual fund industry continually innovating and introducing new schemes, investors have more options than ever to harness the power of compounding. The increasing popularity of Systematic Investment Plans (SIPs) is a testament to this trend, allowing individuals to invest regularly and benefit from the magic of compounding.
With an influx of new investors seeking long-term growth and stability, compound interest is the key to unlocking the true potential of your investments. Whether you're parking your money in a secure bank Fixed Deposit (FD) or navigating the dynamic world of mutual funds, the power of compounding can significantly impact your financial future.
As investors navigate these evolving landscapes, understanding compound interest is not just a financial literacy exercise-it's a critical strategy for achieving long-term financial goals.
What is Compound Interest in Investing?
Compound interest is one of the most powerful concepts in investing, often referred to as 'interest on interest'. It allows your money to grow at an accelerated rate over time. Unlike simple interest, which is calculated only on the principal amount, compound interest is calculated on the initial principal as well as on the accumulated interest from previous periods. This results in exponential growth, making it a key concept for long-term investors.
In this article, we will explore the concept of compound interest in the context of investing in bank Fixed Deposits (FDs) and mutual funds. We have also executed illustrations and calculations to demonstrate how compound interest can work to your advantage.
Compound interest is essentially the process of earning interest on both the principal and the accumulated interest from previous periods. The formula for compound interest is:
Compound Interest Formula
Where:
-
A = the amount of money accumulated after n years, including interest
-
P = the principal amount (the initial money invested or loaned)
-
r = the annual interest rate (in decimal form)
-
n = the number of times that interest is compounded per year
-
t = the number of years the money is invested or borrowed for
The power of compound interest lies in the fact that as your investment earns interest, that interest also begins to earn interest. Over time, this can lead to significant growth in your investment.
1. Compound Interest in Bank Fixed Deposits (FDs)
Bank Fixed Deposits are one of the most common investment options in India. They offer a fixed interest rate over a specified period, and the interest can be compounded on a monthly, quarterly, half-yearly, or yearly basis.
[Read: Why Senior Citizens Should Consider Investing in Bank FDs Now]
Illustration: Compound Interest in FDs
Let's consider an example where you invest Rs 5,00,000 in a Fixed Deposit with an annual interest rate of 7%, compounded annually, for 5 years.
| No. of Years |
Principal Amount (in Rs) |
Interest @ 7% p.a (in Rs) |
Amount at Year End (in Rs) |
| 1 |
5,00,000 |
35,000 |
5,35,000 |
| 2 |
5,35,000 |
37,450 |
5,72,450 |
| 3 |
5,72,450 |
40,072 |
6,12,522 |
| 4 |
6,12,522 |
42,877 |
6,55,398 |
| 5 |
6,55,398 |
45,878 |
7,01,276 |
*This is for illustration purposes only and should be considered a recommendation
After 5 years, the amount would have grown to Rs 7,01,276/-, with Rs 2,01,276/- earned as interest. Notice how the interest earned each year increases because it is calculated on the new principal amount, which includes the interest from the previous year.
2. Compound Interest in Mutual Funds
Mutual funds are a popular investment option that offers the potential for higher returns compared to bank FDs as they are market-linked, however, they come with higher risks. In the context of mutual funds, compound interest works through the reinvestment of dividends or the appreciation of the Net Asset Value (NAV) of the fund.
[Read: Best Mutual Funds for the Next 10 Years]
Illustration: Compound Interest in Mutual Funds
Consider an example where you invest Rs 1,00,000 in a mutual fund with an average annual return of 10%, compounded annually, for 5 years.
| No. of Years |
Initial Investment Amount (in Rs) |
Annual Return @ 10% (in Rs) |
Amount at Year End (in Rs) |
| 1 |
1,00,000 |
10,000 |
1,10,000 |
| 2 |
1,10,000 |
11,000 |
1,21,000 |
| 3 |
1,21,000 |
12,100 |
1,33,100 |
| 4 |
1,33,100 |
13,310 |
1,46,410 |
| 5 |
1,46,410 |
14,641 |
1,61,051 |
*This is for illustration purposes only and should be considered a recommendation
After 5 years, your investment would have grown to Rs 1,61,051/-, with Rs 61,051 earned as returns over the period. The effect of compounding is more pronounced in mutual funds because of the higher rate of return.
3. Systematic Investment Plan (SIP) and Compounding
A Systematic Investment Plan (SIP) allows you to invest a fixed amount regularly in a mutual fund. The power of compounding is maximized when you invest consistently over a long period. This approach fosters disciplined investing, making it an ideal strategy for individuals aiming to build a significant corpus over time.
Given the current market volatility, SIPs are considered a prudent option as they allow investors to buy more units when prices are low and fewer when prices are high. Let's consider an example where you invest Rs 5,000 every month in a mutual fund that gives an average annual return of 10% over 10 years.
| No. of Years |
Total Investment (in Rs) |
Annual Return @ 10% (in Rs) |
Amount at Year End (in Rs) |
| 1 |
60,000 (5000 x 12) |
6,000 |
66,000 |
| 2 |
1,26,000
(+ 60,000 per year) |
12,600 |
1,38,600 |
| 3 |
1,98,600 |
19,860 |
2,18,460 |
| 4 |
2,78,460 |
27,846 |
3,06,306 |
| 5 |
3,66,306 |
36,631 |
4,02,937 |
| 6 |
4,62,937 |
46,294 |
5,09,230 |
| 7 |
5,69,230 |
56,923 |
6,26,153 |
| 8 |
6,86,153 |
68,615 |
7,54,769 |
| 9 |
8,14,769 |
81,477 |
8,96,245 |
| 10 |
9,56,245 |
95,625 |
10,51,870 |
*This is for illustration purposes only and should be considered a recommendation
For instance, if one invests Rs 6,00,000/- which is Rs 60,000/- (Rs 5000 x 12 months) over 10 years, the power of compounding may grow your investment to Rs 10,51,870/- after completion of 10 years, nearly doubling your investment amount.
[SIP Calculator]
Comparing Bank FDs and Mutual Funds
When it comes to choosing between bank FDs and mutual funds, it's essential to consider the rate of return and the power of compounding. Bank FDs are known for their capital protection and fixed returns, making them a preferred choice for risk-averse investors. The interest earned on FDs is compounded periodically, offering steady growth over time.
However, the returns on FDs are generally lower, often just enough to keep pace with inflation, which can limit the growth potential of your savings in the long run.
On the other hand, mutual funds, though subject to market risks, have the potential to offer significantly higher returns. The power of compounding in mutual funds is amplified by the reinvestment of returns and the appreciation of the fund's Net Asset Value (NAV).
Over time, the returns from mutual funds can far exceed those of FDs, especially in equity-oriented funds where the compounding effect is driven by market performance. For investors with a longer time horizon and a higher risk tolerance, mutual funds can provide a more robust path to wealth creation through the compounding of returns.
[Read: Seeking Stability in Uncertain Times: Fixed Income Mutual Funds for Your Portfolio]
Ultimately, the choice between bank FDs and mutual funds depends on your financial goals, risk appetite, and investment horizon. If you seek decent returns with low risk, bank FDs are a reliable option. But, if you're aiming for higher growth and are willing to navigate market fluctuations, mutual funds offer a compelling opportunity to harness the full potential of compound interest.
Understanding how compounding works in both avenues will help you make informed decisions that align with your financial objectives and ensure that your investments grow effectively over time.
To conclude...
In conclusion, the power of compound interest is a fundamental concept that every investor should understand and leverage. By reinvesting earnings and allowing your investment to grow over time, compound interest turns small, consistent contributions into substantial wealth.
Remember, the earlier you start and the longer you stay invested, the more you could benefit from the exponential growth that compound interest offers. Whether through the steady returns of bank FDs or the potentially higher gains of mutual funds, compounding is the key to building a secure and prosperous financial future.
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MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.
She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.
Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.