A famous investment quote by Warren Buffett goes, “If you don’t find a way to make money while you sleep, you will work until you die.” Fortunately, more Indians are recognising the importance of investing. According to a video titled How have the investing habits of Indians changed since independence on MoneyControl, a growing number of us are diversifying our investments beyond traditional options like gold and real estate. It’s no surprise that gold remains a popular choice—Indians collectively hold about 25,000 tons of it, according to the World Gold Council. Real estate has long been a favoured asset for building wealth as well. However, in recent years, there has been a noticeable shift toward financial instruments like Systematic Investment Plans (SIPs), mutual funds, and insurance products.

This brings us to a critical question: How does investing actually grow your money? The answer lies in the concept of compound interest.

Compound interest is the process where the interest earned on an investment is reinvested, generating additional interest over time. This creates a snowball effect, where your wealth accelerates as it compounds, enabling you to build a significant financial cushion over the years. It’s this principle that has helped investors like Warren Buffett amass vast fortunes, and it’s the same principle that can help you achieve your financial goals.

What is compound interest?

Compound interest is a powerful financial concept that can significantly grow your wealth over time. It allows you to earn interest on both the principal and the accumulated interest from previous periods. This means your investment grows at an accelerating rate.

How Compound Interest Works:

Initial Investment (Principal): You start with an initial amount of money, known as the principal.

Interest Calculation: At the end of each compounding period (which could be annually, semi-annually, quarterly, monthly, or even daily), interest is calculated on the current balance of the account, including both the principal and any previously earned interest.

Reinvestment: The interest earned during the compounding period is added to the principal, forming a new, larger balance.

Repeated Compounding: The process repeats itself in the next period, where interest is now calculated on the new, higher balance. This leads to exponential growth of your investment over time.

Example of Compound Interest:

Let’s say you invest Rs.1,000 at an annual interest rate of 5%, compounded yearly.

Year 1: You earn 5% of Rs.1,000, which is Rs.50. Your new balance is Rs.1,050.

Year 2: You earn 5% of Rs.1,050, which is Rs.52.50. Your new balance is Rs.1,102.50.

Year 3: You earn 5% of Rs.1,102.50, which is Rs.55.13. Your new balance is Rs.1,157.63.

As you can see, each year you earn more interest than the previous year, even though the interest rate remains the same. This is because the interest is calculated on the increasing balance.

Which investments have compound interest?

Investing in financial instruments that rope in compound interest can take you closer to your goal of financial freedom. Here are a few investment options that you could consider to reap the benefits of compound interest:

Fixed Deposits

Fixed deposits have a fixed interest rate and a fixed tenure and are considered safe investment options. However, fixed deposits returns are marginal.

Public Provident Fund (PPF)

A long term investment option, the interest on a PPF is computed monthly and compounded annually and is tax-saving. This investment scheme is provided by the government guaranteeing their safety.

National Savings Certificate (NSC)

Another long term investment option supported by the government, NSC can also be used as a collateral for availing loans.

Life Insurance Savings Plans

Some life insurance savings plans combine the benefits of life insurance coverage with a savings or investment component. Helping policyholders build a corpus as well as giving financial protection to the family in case they pass away.

Debt Mutual Funds

A type of mutual fund that invests primarily in fixed-income securities such as bonds, government securities, treasury bills, and money market instruments. These funds are designed to provide investors with a steady income while preserving capital.

Unit Linked Insurance Plans (ULIPs) with Debt Fund investment

ULIPs with Debt Fund investment are financial products that combine life insurance coverage with an investment component focused on investing in debt. These plans offer the dual benefit of insurance protection and the potential for wealth creation through investments in low-risk, fixed-income securities.

Equity Mutual Funds

Also called growth funds, these funds invest your money in stocks of different companies and also allow you to save tax under Sec 80C.

Equity-Linked Savings Scheme (ELSS)

ELSS is designed to offer investors the potential for high returns through investments in equities while providing tax deductions under Section 80C of the Income Tax Act.

National Pension System (NPS)

NPS is a long term investment option that offers a range of investment options, allowing contributors to choose from equity, corporate bonds, government securities, and alternative assets to build a retirement corpus.

Unit-Linked Insurance Plans (ULIPs) with Equity Fund investment

Like ULIPs with Debt Fund investment, ULIPs with Equity Fund investment the dual benefit of life cover and the potential for capital growth through investments in various asset classes, including equity funds. They are eligible for tax deductions under Section 80C of the Income Tax Act, up to ₹1.5 lakh per financial year.

When is compound interest not good?

High-Interest Credit Card Debt

Credit cards often charge compound interest on unpaid balances, meaning if you don't pay off your balance in full each month, interest is calculated on the original amount plus any accumulated interest.

Payday Loans

Payday loans are short-term, high-interest loans that can come with high interest rates. Lenders may charge up to approximately a 4% interest rate daily when you default on your repayment. This could lead to a large debt and a reduced credit score. If you can't repay the loan quickly, the interest compounds rapidly, increasing what you owe.

Auto Title Loans

Auto title loans use your vehicle as collateral and often come with high interest rates. If not repaid quickly, the compounding interest can lead to the loss of your vehicle.

Conclusion

Compound interest, like any other interest, begins to demonstrate its benefits over time. Unlike simple interest, compound interest has the power to significantly grow your wealth by earning returns on both the initial principal and the accumulated interest. While the process requires patience and a long-term perspective, the rewards of compound interest are well worth the wait. The effort and discipline invested today can lead to substantial profits in the future, making it a powerful tool for building wealth over time.

FAQs

How does compound interest differ from simple interest?

Simple interest is calculated only on the original principal amount throughout the investment period, while compound interest is calculated on both the principal and the interest that has been added to it. This means compound interest results in greater growth over time compared to simple interest.

How often is compound interest applied?

Compound interest can be compounded at different intervals, such as annually, semi-annually, quarterly, monthly, or daily. The more frequently interest is compounded, the greater the effect of compounding on the investment growth.

How to maximise the benefits of compound interest?

To maximise the benefits of compound interest, start investing early, make regular contributions, reinvest any earned interest, and choose investments with higher interest rates and frequent compounding intervals.

Disclaimer: The information in this article is compiled from various sources and is not to be taken as a substitute for professional advice on managing finances, reader discretion is advised.