When it comes to investing in fixed income schemes, there are two options that often catch the attention of investors – a scheme that pays 7.5% interest compounded quarterly and a fixed income investment plan that offers 7.7% interest compounded annually. But which one is better? The answer may surprise you, as it lies in the real power of compounding.
First, let’s understand what compounding means. In simple terms, it is the process of earning interest on both the principal amount and the accumulated interest. This means that the interest earned in one period is added to the principal amount, and the next period’s interest is calculated on the new total. This cycle continues, resulting in a snowball effect that can significantly increase the overall return on investment.
Now, let’s compare the two options mentioned above. A fixed income scheme that pays 7.5% interest compounded quarterly may seem attractive at first glance. However, when we calculate the effective annual yield, it comes out to be 7.69%. On the other hand, a fixed income investment plan offering 7.7% interest compounded annually has an effective annual yield of 7.7%. This means that the latter option has a slightly higher return, even though the difference may seem negligible.
But here’s where the real power of compounding comes into play. Let’s assume an investment of Rs. 1 lakh in both the schemes for a period of 10 years. At the end of 10 years, the fixed income scheme with quarterly compounding will give a return of Rs. 2,00,000, while the fixed income investment plan with annual compounding will give a return of Rs. 2,22,000. That’s a difference of Rs. 22,000, which may not seem significant initially, but over a longer period, the difference can be substantial.
Moreover, the longer the investment period, the greater the difference in returns between the two options. This is because the power of compounding increases exponentially with time. So, even a small difference in the interest rate can result in a significant difference in the final return.
In conclusion, while a fixed income scheme with quarterly compounding may seem like a better option due to its higher interest rate, the real power of compounding lies in the frequency of compounding. A fixed income investment plan with annual compounding may offer a slightly lower interest rate, but it can result in a higher return due to the compounding effect. Therefore, it is essential to consider the frequency of compounding while making investment decisions.
