When an investor earns interest on the principal amount along with the interest it incurs, it is called compound interest. Let’s say you invest Rs. 10,000 in a fixed deposit for 2 years at an interest rate of 9% and opt to redeem the interest directly at maturity. During your first year, you accrue Rs. 900 in interest. But in your second year, you accrue 9% interest on Rs. 10,900, which comprises the principal amount plus the interest generated in the first year.
Warren Buffett, chairman of Berkshire Hathaway and one of the most successful value investors in the current era, made 99% of his wealth after the age of 65, making him one of the richest people in the world. Such is the power of compounding. Compound interest is a tool that investors use for financial planning and to potentially build wealth in the long run. The longer one stays invested, the better is the possibility of leveraging the power of compounding.
Additionally, compounding in mutual funds lets you earn returns on returns, and when reinvested back into the mutual funds, it may lead to potentially exponential growth over the years. Under the growth option in a mutual fund investment, the earnings are reinvested into the mutual fund, leading to a snowballing effect on the overall corpus.
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