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Can Compound Interest Beat Inflation?

dateKnowledge Centre Team dateSeptember 01, 2022 views101 Views
Compounding Interest | Compound Interest and Inflation

You earn interest when you invest your money in some financial instrument. There are multiple ways of calculating interest but the two most popular ones are simple and compound interest. In simple interest, you earn interest on the original principal amount whereas, in compound interest, each subsequent interest calculation is done on the principal plus any accrued interest. Compound interest multiplies your money faster but is it sufficient to beat inflation?

Calculate Compounding Interest with Inflation

In compound interest, the interest earned is added back to the principal, before calculating the interest in the next round. So, if the bank has offered you quarterly compounding on your money, the interest earned in quarter 1 would be added to the principal before calculating interest in quarter 2.

The effective yield actually is much higher than the quoted rate of interest in the compounding interest method. It is not uncommon for banks and financial institutions to quote effective yield for investments so that investors are aware of the actual growth.

  • For example: If you invest Rs. 100 at a compound interest of 6% per annum, compounding being done quarterly, the amount at the end of 5 years would be Rs 134.686 (effective yield: 6.94%)
  • If the compounding is done annually, the final amount on maturity would be Rs 133.823 (effective yield: 6.76%)

However, this rate of growth does not signify real growth because the value of money gets eroded over time due to inflation. As of July 2022, the inflation rate in India was 6% which implies:

Real growth = Effective yield - inflation rate
= 6.76% -6%
= 0.76%

So, effectively, you are earning 0.76%

Must Read - Inflation Meaning

Why Consider Inflation with Investments?

The above example of investing Rs.100 was very simplistic. As a serious investor, you may be aspiring to build wealth in the medium to long run. If you invest some lumpsum money such as Rs.10 lakhs, that you received as a performance bonus etc, at a 6% rate of interest in a bank FD, you will receive Rs.13,46,855 at the end of 5 years.

In the real world, you must also factor in taxation, because interest earned on FDs is taxable. If you fall in the 20% tax bracket, you will end up paying Rs.69,371 towards income tax. You are effectively taking a post-tax return of 5.55% or Rs.2,77,484. (total amount of Rs.12,77,484)

If the inflation rate is 6% and your earning is 5.55%, your real earning=5.55%-6%= -0.45%

The buying power of your money goes down with time. To ensure your hard-earned money does not lose sheen, it must grow faster than the rate of inflation. Invest accordingly.

Must Read - Compound Interest Investments

Why Saving is Better Than Borrowing for Large Purchases?

If you are planning to buy a car worth Rs 10 lakhs and have two choices in front of you:

1. Your banker offers you a car loan at 7.5% per annum under the reducing balance method. The loan repayment tenure would be 5 years (60 months).

2. You save Rs 20,000 each month and invest the same at, let's say, 6% per annum in a modest recurring deposit.

Which one should you opt for?

Let’s take scenario #1. If you avail yourself of a loan, you end up paying a total interest of Rs 2,02,277 in 5 years.

Loan Amount (Rs.) Rs. 10,00,000
Monthly Payment (Rs.) Rs. 20,038
Total Interest (Rs.) Rs. 202,277
Total Payment (Rs.) Rs. 12,02,277

In scenario #2, your investment would build a kitty of Rs 14.01 lakhs. This amount can be more if you invest in better financial instruments such as ULIPs.

Saving money to buy a car makes more financial sense.

Best Long-Term Investments for Beating Inflation

Invest in avenues that will beat inflation and help you generate wealth. ELSS and ULIPs are proven to give inflation-beating returns over a 3–5-year period:

i. Equity Linked Savings Scheme (ELSS):

In ELSS, you calculate the compound interest using the formula for Compounded Annual Growth Rate (CAGR). For example, if you invested in an ELSS with a Net Asset Value (NAV) of Rs 50 and the NAV becomes Rs 100 in 5 years, the CAGR = {[(100/50)^(1/5)]-1}*100 = 14.87%

Other features of ELSS which make it useful for beating inflation in the long run are:

- Invests primarily in equity stocks
- Investments are tax-deductible
- Long-term gains are tax-free up to Rs 1 lakh in the year of withdrawal
- Has a short lock-in period of just three years
- You can invest and withdraw systematically
- No maximum limit of investment

ii. Unit Linked Insurance Plans (ULIPs):

ULIPs also work on the principle of CAGR. In ULIPs with annual premium payments, the premium is added to the previous fund.

ULIP investments offer more flexibility and options to you as a diversified investment. Here are the features of ULIP plans you should consider:

- Invest in a mix of equity and debt funds
- Use automated strategies for managing your asset mix as per market
- Added bonuses for long-term investors
- Switch from equity to debt or debt to equity anytime without a tax liability
- Tax-free partial withdrawals are available after five years of investment
- Invest up to the age of 99 with Invest 4G ULIP from Canara HSBC Life Insurance
- You can build a large corpus and have a tax-free pension after 60 with a single plan
- No maximum limit for investment, however, the tax-exempt status applies only for investments up to Rs 2.5 lakh per annum

Learn the difference between ELSS and ULIP.

Inflation Beating Investments for Wealth Preservation

Investments in both ELSS and ULIPs are deductible, from your taxable income, under section 80C. The maturity amount, in ULIPs, is also exempt from taxes. So, that’s an additional saving for you. Both ELSS And ULIP are wealth-building investments, once you have built the wealth you need to preserve it using large assets like real estate, or savings plans.

Saving is essential but what is critical is investing in the right asset classes and financial instruments. Your investments should yield inflation-beating post-tax returns. Tax rebates on investment and maturity will save considerable money. Saving and making large purchases with your savings is better than buying things on credit.

Disclaimer: This article is issued in the general public interest and meant for general information purposes only. Readers are advised to exercise their caution and not to rely on the contents of the article as conclusive in nature. Readers should research further or consult an expert in this regard.

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