In this article, we will discuss
- What is Compounded Interest?
- How Does the Power of Compounding Work in SIP Investment Plans?
- What is the Best Compounding Strategy for SIP Investors?
- What Are the Benefits of Compounding Power in SIP Investments?
- How Can an SIP Calculator Help an Investor?
Most investors use a SIP calculator to determine their returns earned from mutual fund investments made through a Systematic Investment Plan. However, this can also be done manually, considering that they have a clear idea of how the power of compounding works in SIP investments.
In this article, we will discuss all the relevant details regarding the compounding power that an investor keen on SIPs must know. Keep reading to find out more information.
What is Compounded Interest?
Compound interest is the amount of interest calculated on the basis of the initial sum of money invested and the interest income generated over time. Simply put, investors earn interest on the principal amount, and then when the next interest cycle kicks in, the new interest amount is calculated on the total amount of principal and previous interest income.
With compound interest, the earnings of an investor increase periodically throughout the investment period due to reinvestment.
How Does the Power of Compounding Work in SIP Investment Plans?
Compounding is a process where an investor earns interest on the invested funds and reinvests them all together to earn further interest. The power of compounding in SIP investment plans allows investors to generate income not just from the amount they invest but also from the subsequent interest they have earned.
Let’s understand the concept of compounding in a better way by using an example.
Suppose you are planning to invest ₹12,000 in a regular investment instrument other than an SIP plan, earning interest at a 10% rate for 3 years.
Therefore, amount of interest you will earn after every year = ₹(12,000 *10/100) = ₹1,200. So, by the end of 3 years, you will earn ₹3,600 as your interest income.
Hence, the maturity amount of your regular investment will stand at ₹15,600.
On the other hand, if you invest ₹1,000 in a monthly SIP investment plan, offering 10% interest but with compounding power, you can earn greater returns at the end of 3 years.
Let’s find out,
In the first year, interest income will be 10% * ₹12,000 = ₹1,200 and closing balance will be ₹13,200.
In second year, interest income will be 10% * ₹13,200 = ₹1,320 and closing balance will amount to ₹14,520.
In the last year, interest income will be 10% * ₹14,520 = ₹1,452 and closing balance will stand at ₹15,972.
So, by the end of 3 years, you will earn ₹3,972 as your interest income.
Therefore, you can earn an additional return of ₹372 by reinvesting the interest income and using the compounding power.
What is the Best Compounding Strategy for SIP Investors?
Let's take a look at some of the most effective and common compounding strategies used by SIP investors to grow their investments exponentially.
1. Start Early
One of the most common compounding strategies for investors is to start SIP investing from an early age. The effect of compounding power depends upon the investment horizon of an individual. The longer your investment horizon is, the more time you have for your interest income to accumulate and generate significant returns.
All investors must avoid short-term withdrawals from SIP investments until they fully reap its benefits. Once you withdraw or liquidate your funds before the investment period, you miss out on the compounding benefits you have acquired up to that point.
Investors must make timely payments of SIP in order to earn a significant corpus from their investment portfolio. For that, you must consistently save and inculcate a discipline of making regular contributions. Maintain this regular habit and, furthermore, try to increase the amount you invest in your SIPs, if possible.
What Are the Benefits of Compounding Power in SIP Investments?
Let’s find out what are the benefits of compounding power in SIP investment plans.
- As per the compounding strategy, reinvestment of interest income along with initial investment contributes to the growth potential, enabling an investor to generate additional gains.
- Compounded SIPs are an ideal investment plan in which an individual can earn further returns on their return. Simply put, the SIP investment returns become a source of generating income.
- The power of compounding in SIP investments preserves the purchasing power of the initial investment and combats the effects of inflation and other wealth-erosion risks.
- Individuals can reach their investment goals comparatively faster than other investment plans by reinvesting the amount of interest earned in a disciplined manner and accumulating more returns.
How Can an SIP Calculator Help an Investor?
Although the manual calculation of returns from an SIP investment plan might look simple, it gets complex over time due to accumulated interest and increasing balance. Therefore, it is generally advisable to use an SIP calculator rather than calculating compound interest manually.
An SIP calculator or compounding calculator determines an estimated return based on inputs provided by an individual regarding the amount of monthly investment, rate of return and time period. Considering the compounding power of SIP investments, this tool accurately calculates the amount of money you will receive at the end of an investment period.
Traditional approaches to regular savings and investments take a great deal of time to accumulate a significant corpus. A sum of money does not grow on its own by simply being invested. Investments in an SIP plan tend to generate substantial returns over time, thanks to the power of compounding.
Yet, to be safe, make sure to use an SIP calculator to determine whether the compounding power of your preferred SIP aligns with your financial requirements and goals.
Besides SIP investment plans, an investor can also harness the power of compounding by investing in SIP stocks. To do so, you have to open a trading account that fits your investment patterns the most.
Frequently Asked Questions
1. What is a Systematic Investment Plan or SIP?
A Systematic Investment Plan is a method of investing in a mutual fund scheme at regular intervals. Under this method, an investor makes small and fixed payments instead of a lump-sum payment in a disciplined manner to earn a substantial return.
2. What are the modes of SIP investment?
An individual can start investing in a mutual fund scheme through SIP by either using the online or the offline mode. He/she has to open a Demat account in order to invest online, whereas offline investments can be made by visiting a bank or a post office.
3. What is the interval period in a SIP investment plan?
The investment interval period in a SIP plan varies for different mutual fund schemes. Generally, such plans have a monthly interval period. However, it can also involve quarter, bi-annual, or annual intervals as per the investor’s preference.
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