Mutual Fund Compounding: Do Mutual Funds give Compound Interest?

Last updated:
mutual funds compound interest

Understanding Compound Interest

One of the most significant aspects of compounding is that it produces interest from the previously earned interest, in addition to the base capital. In fact, the entire idea of compounding is founded on building a broad base that will continue adding on to the previous earnings.

Suppose, if your initial investment is Rs 2 lakh, compounded 20% per annum for the upcoming 10 years, then you will procure a base of approximately Rs 2,230,084. As visible, compounding results in the creation of a cycle of earnings that will continue to grow over time.

As an investor, you must keep in mind that the most vital point of compounding is that the resulting earnings are generated by reinvestments. Therefore, you must bear with patience and should not at any point be allured to withdraw the returns. The withdrawal of profits will upset the base of the investment growth thus stopping its development into a more significant sum.  

Defining Mutual Fund Returns

Mutual funds are one of the most attractive investments for stock market investors who are looking to diversify their portfolios. In mutual fund investments, investors purchase shares that best fit their financial goals, lifestyle, and risk tolerance. The resulting investment is collected for the usage of investment in other assets thus giving portfolio managers multiple exposures to various other securities.

Understanding mutual funds are to know that even one share of a large-cap fund can lend the investor a certain degree of ownership in a range of different companies. Actively-managed funds are under continuous scrutiny as fund managers reallocate assets for enabling the fund to meet the maximum financial objectives.

There are several different ways in which mutual funds can pay returns to their investors, some of which are discussed below:

  1. Firstly, mutual funds are beneficial for earning money from dividends of the securities that comprise the fund holdings.
  2. Secondly, the fund company usually pays through distributions that you can either take in cash or choose to reinvest them.
  3. Most funds tend to pass on capital gains from the sale of securities to their investors.
  4. Mutual funds can also benefit investors when they sell their shares for a profit.
  5. From the generated returns, capital gains can be reinvested in creating additional profits. 

Compounding in Mutual Funds

Mutual funds are crafted in a manner that lets investors make the most out of the method of compounding. Investors are able to reap great advantages when the value of fund units shoots up. If you invest within a long-term horizon, then the method of compounding will bring major growth in investments.

Suppose, if you have chosen to invest Rs 2000 every month under a mutual fund scheme for the upcoming ten years, with the rate of return being 8% per annum, then you will yield a net profit of Rs 3.87 lakhs. From that, if you choose to invest further for the next ten years, then the reinvested capital will grow even faster, fetching you a profit of Rs 13.36 lakhs.

This unique feature of compounding establishes that your existing investment, in addition to the return on investment as well as the new investment every month, all of it will contribute towards further gains.

Quick results of Compound Interest

If you are still confused about how compound interest factors into mutual funds, keep reading for the ultimate clarification. Basics first, compound interests are paid based on the accrued interest that you earn. Hence, it is calculated grounding on the principal amount in addition to deposits and interest. 

You can simply think of it as interest on interest. Compound interest is one that allows your balance to grow even more quickly than simple interest which takes only the principal amount into the calculation.

As a mutual funds investor, it is easier to increase your compound interest. The logic is quite easy to understand: the longer your investment sits, the higher it grows. Another way of earning from compound interest is to choose to reinvest your fund's dividends. Doing so will enhance your chances of earning more.

Significant rules to reap the methods of compounding in mutual funds

Controlling expenses

The compounding principle works in the same manner whether you are investing Rs. 100 or Rs. 10,000. However, if you have invested a substantial amount, the interest you will earn will also increase exponentially. The most significant method of harnessing the power of compounding is raising your investments. 

However, if you have a limited income, you can multiply your savings by controlling your expenses. You can do so by creating a budget and identifying the areas where you will be able to reduce costs on a monthly basis. Not many know but spending wisely can multiply the savings which can, in turn, be invested more for getting higher returns.

Starting early

Starting early on is the biggest secret to multiplying investments. You must ideally start investing the very moment you set on to a job. It is a myth to wait for investing once you have a better salary, rather you should start investing when you start earning. 

However, if you are already past that stage, start investing right now. Once you start investing early, you have a solid base for the expansion of funds in the future thanks to the method of compounding. If you are unaware of calculating your return on investment, you can take the help of an online calculator. Calculating helps investors chalk out their future goals better.

Practice discipline 

Discipline is the surest key to success. Creating a healthy corpus, and investing regularly from the start are some ways you can ensure investment discipline. It isn’t a wise decision to skip the SIP payments as it hampers the financial disciplining factor. When you keep investing regularly month after month, you increase your savings and also develop a certain discipline.

Have Patience

Many investors in the stock market are always on the lookout for chasing the quickest returns. However, in their attempt to earn some fast bucks, they tend to make huge mistakes that can lead to even bigger losses. As we saw in the above examples, compounding multiplies over time. Therefore, one must learn to practice patience and consider a long-term approach toward investing.

Remember, you don’t have to be a financial expert to reap the huge benefits of compounding. Every investor is empowered to make profits from the concept of compound interest if they put it to good use.

  • How is MF compounded?

  • Is SIP based on compound interest?

  • Is a mutual fund compounded monthly?