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The Power Of Compounding, And How It Works In Mutual Funds

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Created on
July 9, 2022


What’s Inside

When it comes to Mutual Funds, many of us have heard cautionary tales from parents, elders, and family members. They firmly believe that investing is risky, often sharing stories of distant relatives who lost their fortunes in the market. This mindset stems from a need for more exposure to the benefits of investing and compounding.

With research, self-awareness, and a keen understanding of time, it's possible to discover how to mitigate risks and leverage the power of compounding. In this blog, we delve into insights on the advantages of investing early, the wonders of compounding interest, and practical strategies to make it work.

Compound Interest: Where 1+1 = 2.5!

Compound interest is interest on your principal investment and the interest generated over time. In other words, when you regularly invest at a specific interest rate, you get returns on the original investment.

Moreover, as time progresses, the original amount keeps growing due to adding regular interest (reinvestment) to the main corpus. Naturally, the absolute returns received, thus, become significantly higher and continue to do so throughout the investment period.

Making Your Money Work at The Speed of Compounding

The true power of compounding can be easily understood by using an example. Suppose person X invests ₹1 lakh in a financial instrument that gives an assured return of 10% per annum. For a five-year investment tenor, the calculation for simple interest (or interest on principal) is like this.

10% of 1,00,000 = ₹10,000 is the interest amount each year. Multiplied by 5, the absolute returns are ₹50,000, and the final amount is ₹1,50,000 throughout the investment period.

But what if person X also chooses to reinvest the yearly interest amount? Reinvesting this interest amount with the initial amount is known as compounding. How would compounding interest make the final return look? Let’s see:

Year 1: 10% of 1,00,000 = ₹10,000. Total corpus = ₹1,10,000.

Year 2: 10% of 1,10,000 = ₹11,000. Total corpus = ₹1,21,000.

Year 3: 10% of 1,21,000 = ₹12,100. Total corpus = ₹1,33,100.

Year 4: 10% of 1,33,100 = ₹13,310. Total corpus = ₹1,46,410.

Year 5: 10% of 1,46,410 = ₹14,641. Total corpus = ₹1,61,051.

By simply reinvesting the interest earned, person X has gained an additional ₹11,051 in the same financial tool over the same investment period — which means a windfall of 11.05% over the traditional investment approach. It is easy to imagine how the savings can go up exponentially when invested over more extended periods—the same ₹1,00,000 more than doubles and becomes nearly ₹2,68,506 if invested for 10 years, and so on.

What Equity Mutual Funds Can Do to Your Savings

Even if you're not interested in investing directly in the stock market, equity mutual funds can still provide market-linked investments. Here are three ways these funds can help grow your savings and create wealth over the long term:



Compounding Generates Profits Over Time

Reinvesting earnings to generate additional returns. Equity mutual funds with a growth plan automatically reinvest profits in the scheme. Over time, you can earn interest/returns on your previous gains, resulting in significant growth.

Long-Term Wealth Creation

Despite short-term market volatility, equity investments have historically provided notable returns over the long term. By staying invested in equity funds for more than five years, you can take advantage of this and even out the effects of volatility.

Tax Saving Benefits

According to the Income Tax Act, 1961, long-term capital gains on equity mutual funds (i.e. profits realized after a holding period of at least 12 months) are exempt from taxes up to Rs. 1 lakh per financial year. You can plan to redeem your mutual funds accordingly to earn tax benefits in the process.

Here's a detailed article about how equity mutual funds can help you unlock the next level of savings.

Why Starting Early With SIPs is Important?

Not only starting early, but experts also recommend staying invested longer to build a healthy corpus. A quick buck here and there will only get you so far. While there are various investment avenues, mutual funds are the most convenient, simple and effective.

The convenience and simplicity stem from the fact that the entire process is online and provides many options. With just a few taps, you can invest a fixed amount as a lump sum or choose to have smaller amounts deducted each month using a Systematic Investment Plan.

Types of Mutual Funds to Choose

Selecting the right one requires understanding your risk appetite, investment style, and preferred investment period. You can invest in equities, which may come with higher risk and higher returns. Or you can choose to invest in low-risk, stable, fixed-income security funds. There is something out there for everyone.

Mutual funds are genuinely effective in building long-term wealth and allow the option of diversification too. Remember the phrase ‘don’t put all your eggs in one basket’? It also holds while investing, so you can create a balanced corpus using the different types of mutual funds available.

While starting, you may invest through a broker or a fund house with some minor charges (such as commission). Once experienced, you can invest in direct funds and save on the commission, which gets added to your corpus instead.


Investing early and harnessing the power of compounding interest is not just a strategy for the financially savvy—it's a pathway to financial freedom for anyone willing to take the leap. By understanding the concept of compounding, reinvesting your returns, and utilising suitable investment vehicles like mutual funds, you can set yourself on a trajectory towards long-term wealth accumulation. The risks may be present, but with proper research, self-awareness, and a long-term perspective, you can significantly reduce those risks and enjoy the benefits of compounding over time.

Fi: Empowering Investors with Commission-Free Mutual Funds

Mutual Fund investments on Fi are simple & commission-free. With its intuitive user interface, suited for new & seasoned investors, one can select from over 900 direct Mutual Funds. Plus, Fi is 100% secure as it functions under the guidance of epiFi Wealth, a SEBI-registered investment advisor. To help simplify the steps involved, you can invest daily, weekly, or monthly via automatic payments or SIPs — created with one tap. Moreover, Fi offers 100% flexibility with zero penalties for missed payments.

Read on about mutual funds here

Frequently Asked Questions

1. Is mutual fund interest compounded monthly?

Mutual fund interest rates do not compound monthly. It grows as the fund does. You could invest in a mutual fund and tap into your earnings years later. Your interest grows based on the amount you have invested and the duration you've been investing for.

2. Which fund is best when it comes to compounding interest?

Here are some of the best options for compound interest -

  1. Index funds
  2. Mutual funds
  3. ETFs
  4. Dividend-paying stocks
  5. Banking bonds

3. Does an SIP provide compound interest?

Systematic Investment Plans, or SIP, rely on the power of compounding. It's reinvesting your investment returns to earn even more returns. By investing a fixed amount of money at regular intervals, you can use compounding to grow your investments over time with SIPs.

4. Why is there no compounding in mutual funds?

Compounding in mutual funds is more complex than other investments. When you invest in a mutual fund, you can automatically reinvest your dividends or capital gains. It means that instead of receiving cash payouts, the money is used to purchase additional mutual fund units. Over time, this can lead to compounding returns as the other units purchased with reinvested dividends or capital gains generate their returns.


Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.
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