We have compiled our fresh article explaining how compounding works in mutual funds and how it can benefit you if you start at the right age. We have added an example and various other terms to help you understand this important term. So, keep reading here and go through each point carefully.
What is Compounding in Mutual Funds?
Compounding or compound interest can be understood as the process of reinvesting earned interest on the principal amount. The new interest is calculated based on the new principal amount. The same process keeps taking place till the maturity of the investment. For example, if you invest Rs 1,00,000 at the interest rate of @12% for five years, you earn compounding interest. You will have Rs 1,76,234.1, where you will earn Rs 76,234.1 interest money. However, if you get interested in a straight line or simple method, you will only earn Rs 50,000.
In mutual funds, you invest your hard-earned money using SIPs. It’s a systematic and disciplined way to increase wealth in the long term. You make periodic deposits in selected mutual fund schemes where you mainly earn dividends and capital gain. And when the earned interest is reinvested under the same plan, you will be able to reap the full benefit of compounding.
How Does Compounding Work in Mutual Funds?
We have already covered a small example of how compounding in mutual funds works. However, if you still have some confusion, you can look at the below-mentioned example.
Suppose you invested Rs 100 in a mutual fund plan and earned Rs 5 interest on your investment. In the next compounding cycle, your interest will get added to the principal amount, which is Rs 105 instead of Rs 100. This compounding cycle will keep functioning until the maturity data arrive. However, if you want to get the full benefit of compounding, it’s required to start investing in the early stage. Let’s also understand this with the below-mentioned step.
In condition A, you invest Rs 2,000 monthly in mutual funds during your 30s and earn a Rs 10% interest rate. Hence, if you complete your 50s, you will have Rs 15.5 lakh. However, if you start investing in mutual funds after your 40s, you will have less wealth when you retire. Moreover, you do not only need to invest your money early, but you will also have to keep your money in the mutual fund for the long term so that it can show you the power of compounding.
Benefits of the Power of Compounding
1. High Wealth Accumulation
High wealth accumulation is one of the biggest benefits of compounding. It helps you get high wealth with the same interest rate under geometric progression. As a result, it makes a big difference between the final corpus and maturity date.
2. Works as Bridge in Shortfalls in Corpus
Sometimes industry witnesses a shortfall in the targeted investment. However, by making the right investment decision under mutual fund SIPs, you can easily fill the gap between shortfalls in the corpus.
3. Maintain Better Growth with Inflation
As an investor, you know that the inflation rate is growing daily. If you wish to maintain the investment valuation higher, you must consider compounding interest instead of simple interest on your investment. However, before making your mutual fund investment, you must also do some research and select an ideal plan that originally matches the inflation rate.
Tips to Get Maximum Benefits of Compounding
Here are some tips that will help you get the maximum benefit of compounding in mutual funds and increase wealth at a high rate.
1. Start at Early Age
Many investors consider investing when they reach their 40s or when they have sufficient funds to invest. But it may be something that can keep you away from enjoying the real benefit of compounding. Investing Rs 3,000 at a @13% interest rate at 25 years will give you a much better return than Rs 5,000 at @13% interest at 40 years of age.
2. Minimize Expenses
It’s another tip you must consider while deciding the SIP amount. If you invest more money from an early age, you will earn more interest and make more wealth. Hence, it’s good to start minimizing monthly expenses and increasing the amount of SIP. So, you earn a high return in the long term and enjoy financial freedom.
3. Maintain Patience
Many investors chase investment options that give a quick result. They miss great opportunities to earn a few bucks in the short term. However, if you have some great plans to make sustainable wealth. You must maintain discipline and patience, which do not require financial expertise. If you can keep investing in predefined monthly SIPs for a definite period, you will surely have some good returns.
Conclusion
Compounding in mutual fund work effectively and has the potential to drive significant results in the long term. However, to reap maximum benefit, it’s crucial to start investing in SIPs early and maintain consistency and patience. If you succeed in doing so, you will be able to earn much better interest rates than regular income sources. Thus, we hope you have a clear idea of how compounding in mutual funds works and can help you make wealth.