“If you invest ₹1000 every year for 20 years, you will earn an additional ₹ 13,000 if the interest is 10% instead of 8%.” “The same amount of money invested at the same rate over a different number of years will yield different interest.”
It is not difficult to come across such statements in today’s world. Everyone is trying to save and invest. But not everyone is making wise decisions. Herd mentality is one of the culprits people switch from long-term to short-term outlooks. Today, let’s dive deep and understand the types of interest, interest income, and how it is calculated.
What is interest?
Interest is the cost of borrowing money, where the borrower pays a fee as the percentage of the total amount to the lender for every year the money is borrowed. In the case of savings and investing, consider that you are the lender and the bank, mutual fund, a company issuing shares, etc., are the borrowers. These institutions, therefore, pay you a fee for borrowing the money. This fee is an interest income for you.
Interests are calculated on a simple or compound basis.
Simple Interest vs Compound Interest
Simple interest is paid or received over a certain period as a fixed percentage of the amount borrowed/lent. Example:
Ravi deposits ₹ 20,000 for 3 years at 10% simple interest at the bank. In this case, Ravi will be receiving ₹ 2,000 per annum for 3 years as the interest. Here, ₹ 20,000 constitutes the principal, ₹ 6,000 is the interest, and the sum of both, ₹ 26,000, is the final amount receivable.
Compound interest accrues the interest. The interest for one term is added to the principal amount in the following year. So, interest is paid or received on the principal and accrued interest. Example:
Ravi deposits ₹ 20,000 for 3 years at 10% compound interest in a mutual fund, compounded annually. In this case, Ravi will be receiving ₹ 2,000 as the interest for first year, ₹ 2,200 as the interest for second year (calculated as 10% of ₹ 20,000 (principal) + ₹ 2,000 (1st year’s interest)), and ₹ 2,420 for the third year (10% of ₹ 20,000 + ₹ 2,000 + ₹ 2,200). Here, ₹ 20,000 is the principal, ₹ 6,620 is the interest income, and the sum of both is the final amount receivable.
Simple interest is elementary, but compound interest is difficult to calculate and, therefore, difficult to wrap your head around. The power of compounding seems like a complicated topic. It is not. Allow us to borrow 2 mins of your time to explain.
The Power of Compounding
Compounding is a long-term investment strategy that allows you to earn interest on the principal investment and the interest earned, which is reinvested over time. In this case, the earnings grow at an increasing rate.
For example, banks compound interest quarterly in a recurring deposit (RD). After every quarter, the interest earned is added to the principal. Therefore, the new amount earns additional interest on the interest from the first quarter. In the third quarter, the additional interest is received on the interest earned in the previous two quarters. This cycle keeps up until your RD matures.
Similarly, compounding allows you to multiply your money’s worth exponentially in a mutual fund. In the case of mutual funds, this means re-investing your interest or dividend and receiving additional units. You earn interest on the principal and the interest or dividend income from the previous term by reinvesting.
To understand the additional income in compounding, let’s go back to Ravi’s example. In this case, he saved over two different interest calculations at the same rate for the same time. However, he earned an additional ₹ 620 over three years when the interest was compounding. If the amount were invested for another two years, the instrument with compound interest would yield ₹ 2,210 over and above the simple interest. In 7 years, an additional ₹ 4,974 over simple interest.
In the mutual fund, Ravi earned an additional 3.10% interest on principal in 3 years, 11.05% in 5 years, and 24.87% in 7 years. Ravi doubles his deposit with the bank in 10 years, whereas Ravi doubles his investment in a little over 7 years in the mutual fund.
Compounding is a lifelong advice
Compound interest causes your wealth to grow faster, as seen in the example, every factor being the same, compound interest doubled Ravi’s money in 7 years. An investment made for 10 years as the bank deposit will yield an additional 59.38% return on principal. However, these calculations are based on an assumed 10% interest at the bank and with the mutual fund, the actual percentages will vary wildly. This example only explains the essence of compounding.
Take another example now. Imagine Ravi understood how compounding works. In one scenario, he understood before he deposited with the bank and in another, he understood after the 10 years he took to double his money with the bank.
Ravi invested in a mutual fund for 30 years in the first case. He will earn a total interest of ₹ 328,988. He is 10 years late and invested only for 20 years in case two. He will now earn a total interest of ₹ 114,550. The interest rate and compounding were the same in both cases. However, Ravi earned an additional ₹ 214,438 in the 10 more years he invested in the first case.
Compounding lets you reach your financial goals in a shorter period. In other words, the earlier you start investing, the greater your wealth. With enough investments, the most exciting part is that you can ideally check your lifestyle inflation and grow it at a better rate than others.