Because SIP is a long-term wealth-creation tool, the compounding effect can be multiplied by long-term investment.

Investing in mutual fund schemes through the Systematic Investment Plan (SIP) mode helps you take advantage of compound interest.

There is an oft-quoted quote that Albert Einstein once called compound interest the eighth wonder of the world. Well, whether he said it or not may be a matter of debate, but the power of compound interest is a lesson for those who want to understand the management of their personal finances.

Before delving into the “power” of compound interest, first understand what compound interest is.

Compound interest is interest on a deposit calculated both on the principal amount and on the interest received over periods.

What is the “strength” of compounding?

With the many investment options available, the chances of making money on your money are also high. Even small investments such as SIPs can bring in a good pool of money over a period of time. However, while we are talking about saving money and earning interest on it, the compound interest method is the deciding factor.

Compound interest, also known as “interest on interest”, refers to the interest accrued on the initial deposit (principal), including all accrued interest.

See also: SIP or lump sum payment? Factors to consider before investing

The stock market, as well as several government-run schemes, operate on a compound interest basis.

In the stock market, mutual funds can allow you to create significant long-term wealth if your investment decisions are timely and sound.

The amount of interest you earn on your savings continues to be added to the principal amount, and then the interest amount is calculated on the new principal amount (original amount + interest earned). Now, as the principal continues to grow every year, so does your profit. This is the power of compounding.

In simple terms, compound interest means that you get interest not only on the principal amount of the debt, but also on the interest that is constantly added to it.

If a person invested Rs. 1 lakh in investment vehicle. Here is how it will grow over 5 years at different expected interest rates. (Source: Paysabazar)

Many investors in the early days of their investment tend to underestimate or ignore the fact that the interest compounding effect is an important accelerator of wealth growth and the creation of a large corpus over a period of time.

SIP and compounding strength

Investing in mutual fund schemes through the Systematic Investment Plan (SIP) mode helps you take advantage of compound interest.

Because SIP is a long-term wealth-creation tool, the compounding effect can be multiplied by long-term investment.

See also: Confused about the types of mutual funds? What are stocks, debt or hybrid funds; Check details

Motilal Oswal provided the following simple example to demonstrate the power of compounding on his website.

Raj and Rekha both invested Rs 50,000 in an investment that pays 10% per annum for ten years. Raj prefers simple interest while Rekha prefers compound interest. The Raj will have a total corpus of Rs. 1 lakh after ten years. Rekha, on the other hand, will receive Rs. 1.30 lakh.

This is due to the fact that in the situation with Raj, interest was charged exclusively on rupees. 50,000 original principle. However, in the Rekha situation, the interest earned each year was added to the principle for calculating the next year’s interest. This greatly increased her profits.

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Namit Singh Sengar Namit is Senior Associate Editor of News18.com Business Vertical. With over five years of experience, he focuses on personal finance, brands, and economics….Read More