See the Power of Reinvesting Mutual Fund Returns with A Compounding Calculator
When it comes to growing wealth, one of the most powerful financial concepts is compound interest. Compounding – which happens when the returns on an investment earn additional returns – can exponentially increase the value of your assets over time.
However, visualising the potential impact of compounding on your wealth can be difficult without the right tools. This is where a compounding calculator can be helpful.
This free online tool helps you understand how much your investment can potentially grow over time through the effect of compounding.
This article tells you more about compounding, how to use a compound calculator, and how reinvesting mutual fund returns can optimise the impact of compounding.
Understanding compounding
Compounding is the process of earning interest not only on your initial principal but also on the interest that accumulates over time. Unlike simple interest, where you earn interest only on your principal, compound interest can grow your money exponentially because the principal increases with each compounding interval. Therefore, you can get higher returns with each cycle.
In the context of mutual funds, it is not interest that you earn but returns on your investment. When the market value of your investments goes up, you earn returns. When the value dips, your returns drop. If these returns are not withdrawn, your effective invested capital grows each time your investment value increases, and you go on to earn returns on your returns. This can result in exponential wealth growth in the long term.
The power of reinvestment
When investing in mutual funds, you can choose between the growth, IDCW payout, or IDCW reinvestment options. In the growth option, your returns stay within the fund. In IDCW (Income Distribution cum Capital Withdrawal), a portion of your investments may be released as income to you from time to time.
The full potential of compounding can be realised when you reinvest these returns. Reinvesting means that instead of withdrawing these earnings, you put them back into the scheme so that they can receive further market exposure and potentially earn more returns. This can create a snowball effect, where your returns can grow exponentially over a period of time as the invested base (principal + reinvested returns) continues to increase.
Using a compounding calculator helps you visualise the effect of compounding on your reinvestment. Most such calculators assume that you will reinvest your earnings. Based on your investment amount, horizon, and interest rate (or expected return rate), the calculator shows you how much your investments can potentially grow over time. The longer the horizon, the more pronounced the effect of compounding.
This helps you understand the exponential growth potential that reinvestment enables. This tool is especially valuable for long-term investments like retirement funds, where compounding over decades can potentially result in significant wealth accumulation.
Step-up SIP: Amplifying the power of reinvestment
Aside from reinvesting returns, another way to boost your return potential is to increase your contributions steadily. This is where a step-up SIP comes into play. A Systematic Investment Plan (SIP) allows you to invest a fixed amount in a mutual fund at regular intervals, typically monthly. The step-up feature enables you to increase this contribution periodically, such as annually, to align with income growth or changing financial goals. A step-up SIP calculator can help you see the efficacy of this strategy.
For example, if you start with a Rs. 5,000 monthly investment and use a step-up SIP to increase your contribution by 10% each year, a step-up SIP calculator will help you see how these incremental top-ups can add up over time.
Let’s compare two scenarios to illustrate the impact:
Fixed SIP: You invest Rs. 5,000 per month for 20 years at an average return rate of 8%. Over 20 years, your total investment would be Rs. 12,00,000, and the value of your investment would be approximately Rs. 29,45,100.
Step-up SIP: If you do a step-up SIP in the same scheme, after 20 years, you would have invested Rs. 34,36,632 and can potentially earn Rs. 65,93,700.
The step-up strategy, combined with reinvestment, can significantly boost the compounding process, helping you achieve significantly higher returns over the long term. Do note, however, that the calculator’s estimates are based on your inputs and there is no assurance that returns will be along expected lines.
As we can see, the true potential of compounding is unleashed when you reinvest your returns and continuously grow your investment base. A compound interest calculator helps you visualise this exponential growth, showing how reinvesting interest, dividends and capital gains can significantly increase the value of your investments over time. With such tools, you can plan your financial future more effectively, optimising your wealth-building potential through the power of compounding.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
Disclaimer: This article is published in association with Bajaj Finserv and not created by TNM Editorial.