Compound interest is one of the most powerful forces for wealth creation over the long run. By reinvesting returns, the compounding effect causes balances to grow exponentially at an accelerating rate. Indians can harness this force through smart investment and savings habits. Read on to understand how compound interest works and how it can help build a comfortable financial future by investing in top mutual funds.
What is compounding?
Compound interest refers to interest earned on interest. When interest is added to the principal amount rather than withdrawing it, you start earning interest on that accumulated interest as well. This is called compounding. It causes the overall returns to grow at an increasing rate rather than linearly over time. The longer the time period and frequency of compounding, the greater is the impact.
Compound interest calculator
There are online compound interest calculator that let you simulate investment returns depending on factors like principal amount, annual interest rate, compounding frequency and time. Playing with different assumptions in a calculator helps visualize how small changes in variables can significantly alter end balances. It drives home the importance of starting early to benefit maximum from the power of compounding.
Long term investment
The more extended the investment horizon, greater is the impact of compound interest in multiplying wealth. For example, ₹10,000 invested annually for 30 years at 10% interest compounded annually will grow to around ₹32 lakhs. However, the same investment for just 5 more years till age 35 will be worth a whopping ₹1.05 crores – over three times more. Starting early and staying invested for decades allows compounding to work its magic.
Power of time
The longer your money remains invested, the faster it grows due to compound returns. For instance, a monthly SIP of ₹5,000 in a fund offering 12% annual returns will grow to ₹1 crore in 25 years but take 29 years if the same SIP plan starts 5 years later. Letting compound interest act for additional years can make a substantial difference to corpus size.
Compound at regular intervals
The more frequent the compounding, the larger the returns. For example, daily compounding provides a slightly higher return than annual compounding for the same interest rate and term. Investors should consider options like monthly SIPs or automated deductions to put idle money to work compounding throughout the year.
Financial experts recommend starting to harness the power of compound interest as early as possible by systematically investing even small post-tax surplus in long term asset classes like equities or debt funds. Disciplined SIPs help remain invested through market cycles to earn higher risk-adjusted returns compounded over decades. Automating the process further eases the practice.
A judicious use of a compound interest calculator and unlocking this phenomenon’s potential through regular disciplined investments can aid in building a sizeable corpus for life goals like retirement, children’s education or succession planning over the long run with relatively small monthly outflows. Starting early, staying invested long term and maximizing compounding frequency compound the power of compounding.