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 the tenure, the fixed income scheme will give a return of Rs. 2,00,000, while the fixed income investment plan will give a return of Rs. 2,22,000. The difference of Rs. 22,000 may not seem significant, but when we look at the effective annual yield, the fixed income investment plan has given a return of 7.7% on the initial investment, while the fixed income scheme has given a return of only 7.69%.
This may seem like a small difference, but when we consider a longer investment horizon, the gap between the two options widens significantly. For instance, if we extend the investment period to 20 years, the fixed income investment plan will give a return of Rs. 5,00,000, while the fixed income scheme will give a return of Rs. 4,90,000. The effective annual yield for the fixed income investment plan will be 7.7%, while for the fixed income scheme, it will be 7.69%. This means that the difference in returns has now increased to Rs. 10,000, and the effective annual yield for the fixed income investment plan is higher by 0.01%.
In conclusion, while a fixed income scheme that pays 7.5% interest compounded quarterly may seem like a better option, the real power of compounding lies in a fixed income investment plan that offers 7.7% interest compounded annually. This small difference in returns can make a significant impact on your overall investment portfolio, especially in the long run. So, it is essential to consider the effective annual yield and the power of compounding while making investment decisions.
