We often hear that this investment scheme offers compound interest. Investment firms advertise compound interest schemes as something which will skyrocket your investment to greater heights. While many of us see compounding as a tool to multiply wealth, seldom do we inquire what is it and how does it work to boost our investment growth. Some of the investment options that provide compounding interest/returns are Employees Provident Fund (EPF), Public Provident Fund (PPF), mutual funds, fixed deposits, and life insurance plans.

Investment schemes can offer compound interest quarterly, half-yearly or yearly. Know how compounding works in these plans and how a Rs 5,000 systematic investment plan (SIP) in a mutual fund(s) can help you generate a corpus of Rs 1.76 crore in the long run.

What is compounding?

Compounding is the interest on interest, which means you get interest not only on the principal amount but also on the overall value.

E.g. When you invest Rs 1 lakh lump sum in an investment scheme such as mutual fund and get a 12 per cent annual return on it, at the end of the year, your investment grows to Rs 1.12 lakh. If your continue it for the second year, for the next compounding cycle, you get returns on Rs 1.12 lakh and not on your principal amount of Rs 1 lakh.

When you continue this investment for many years, there comes a stage, where just your one-year interest/capital gains becomes larger than your principal.   

Compounding in mutual fund

Compounding in mutual funds is calculated annually, where you get returns on the overall corpus and not just on your lump sum or SIP investment.

E.g., when you invest Rs 1 lakh lump sum in a mutual fund scheme for a long term and get a 12 per cent return every year, then this is how your future value of investment will look like after 10, 20, and 30 years.

After 10 years, your long-term capital gains will be Rs 2.11 lakh and the total value will be Rs 3.11 lakh.

After 20 years, your long-term capital gains will be Rs 8.65 lakh and the total value will be Rs 9.65 lakh.

After 30 years, your Rs 1 lakh principal will get capital gains of Rs 28.96 lakh and the overall return will be Rs 29.96 lakh. 

What we see here is that your Rs 1 lakh investment gives different returns in different decades even though the annual rate of return is 12 per cent.

What is even more significant is that in the first decade, capital gains are of Rs 2.11, but for the next two decades, they swelled to Rs 8.65 lakh and Rs 28.96 lakh, respectively.

It becomes possible only because of compounding. The longer you stay in your investment, the faster your investment grows because of compounding.

How Rs 5,000 SIP will grow into Rs 1.76 crore

Here, we won’t make a lump sum investment, but will pick a Rs 5,000 SIP investment to how how a small amount compounded for the long term can grow into a huge corpus.

If you invest Rs 5,000 SIP a month, or Rs 60,000 a year in a mutual fund(s) and get a 12 per cent return on your investment, after 10, 20, and 30 years, your investment report will look like this-

After 10 years, your investment will be Rs 6 lakh, your long-term capital gains will be Rs 5.62 lakh, and the future value will be Rs 11.62 lakh.

After 20 years, your investment will grow to Rs 12 lakh, long-term capital gains will be Rs 37.96 lakh and the total value of your investment will be Rs 49.96 lakh.

After 30 years, your investment will be Rs 18 lakh, long-term capital gains will be Rs 1.58 crore, while the total value will be Rs 1.76 crore.

Here, what you see is that in every decade, you have invested Rs 6 lakh, and your annualised returns grow at a 12 per cent rate, but that investment gives your Rs 5.62 lakh, Rs 37.96 lakh, and Rs 1.58 crore, respectively, in different decades.

This shows the power of compounding.

Thirty years is a long time and one needs a lot of patience to stick to their investment for that long.

But compounding tests your patience, and once you give your investment time to grow, compounding converts your small contributions into a large corpus.

So, they key is to start investing early even if you start it with a small amount.

If you start at 25 years of age and invest Rs 5,000 in a SIP, you can have a corpus of Rs 1.76 crore corpus by the age of 55.

(Disclaimer: Calculations here are for information purpose only. Do you own research or consult an expert before making an investment).