Power of Compounding

Power of Compounding

08 Aug 2019

The idea of saving something good for later is beneficial for individuals. It is true that there are investors who do not understand the benefits of saving for the future. Compound Interest is calculated by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compound periods minus one. The total initial amount of the deposited is then subtracted from the resulting value.

The formula for calculating Compound Interest is:

Compound Interest = Total amount of Principal and Interest in future (or Future Value) less Principal amount at present (or Present Value)

Make a three-year deposit of Rs.10,000 at an interest rate of 5% that compounds annually. What would be the amount of interest? In this case, it would be: Rs,10,000 [(1 + 0.05)3 – 1] = Rs.10,000 [1.157625 – 1] = Rs.1,576.25.

KEY TAKEAWAYS

  • Compound interest (or compounding interest) is interest calculated on the initial principal, which also includes all of the accumulated interest of previous periods of a deposit or loan.
  • Compound interest is calculated by multiplying the initial principal amount by one plus the annual interest rate raised to the number of compound periods minus one.
  • Interest can be compounded on any given frequency schedule, from continuous to daily to annually.
  • When calculating compound interest, the number of compounding periods makes a significant difference.

When calculating compound interest, the number of compounding periods makes a significant difference. The basic rule is that the higher the number of compounding periods, the greater the amount of compound interest. Some investors reap the benefits right away once their investments start earning really good returns.

Let us understand this with the help of this example - Rs. 1 lakh invested at an interest rate of 10% per annum over periods of 5, 10, 15, 20, 25 and 30 years translates into maturity amounts ranging from Rs. 1.61 lakhs after 5 years to Rs. 17.45 lakhs after 30 years. The compounding effect is clearly visible as the extra amount earned in each of the 5 years is exponentially rising. The gain in the first 5 years is Rs. 0.61 lakh while in the next 5 years it is Rs. 0.98 lakh. This increases to Rs. 2.55 lakhs between the 15th and the 20th year and Rs. 6.61 lakhs between the 25th and the 30th year.

Compound interest can significantly boost investment returns over the long term. Translated into a human lifetime, it means that someone who saves for 30 years earns over 17 times the principal compared to someone who saves for 20 years and earns only 7 times the principal and so on. If one has time to learn just one thing about investing, then it should be this. In short, one needs to start saving early and for longer periods of time to achieve the full power of compounding.

The finest benefits of tax saving investments are always observed over longer periods of time and this is because the power of compounding really starts showing its magic over the long term. Investments such as ELSS funds, National Savings Certificate and Public Provident Fund earn compounding interest.

Let us compare ELSS with Fixed Deposits in terms of risk, rewards and taxation -

Mutual Fund or ELSS returns are linked to the market they invest in and are completely dependent on the performance of the stock market while Fixed Deposits offer fixed and guaranteed returns at a pre-defined rate of return over a specific time period. The risk involved in a mutual fund varies from fund to fund and is mostly influenced by the market.

Meanwhile FD’s with banks carry zero risk as the depositor will receive guaranteed returns at a fixed interest rate. On the taxation part, all mutual funds are subject to short term and long term capital gains tax. STCG is charged at a flat rate of 15%, whereas LTCG is charged at 10% of the earnings above ₹1 lakh but FD’s are subject to 10% TDS on interest earned above ₹40,000 over a financial year, while this limit is Rs. 50,000 for senior citizens (includes interest earned on savings deposits, FDs, along with other deposit schemes in banks and post offices). This essentially means that the higher the risks you take, the higher the returns you get.

Compound interest is termed as adding interest of one year to the principal of next year and in the second year, interest is earned on both the interest and the principal. The results end up being phenomenal whenever this happens year after year.

Founded in 2005 by new–age entrepreneur Abhishek Bansal , Abans Group has evolved multi-fold from being just a trading house to a quintessential diversified business group, providing expertise in Broking Services, Non-Banking Financial Dealings, Financial Services, Agri-Commodity Services, Warehousing, Realty & Infrastructure, Gold Dore Refinery & Manufacturing, Trading in Metal Products, Pharmaceuticals, Software Development & Wealth Management. The Group is a comprehensive financial and non-financial services and solutions provider, aiming to provide end-to-end solutions to its clients.