Do we understand compounding

State Bank of India , is coming out with a Bond Issue and one of the Investment Option is a 15 Year bond with 9.95% interest rate . When I mentioned this to a friend of mine , his immediate reaction was , wow this is better than PPF ( 15year , 8% ) . This made me think , how little we understand compounding

These are how the SBI bond issue and PPF are different , I would be considering just the duration and Interest rate and keeping all other issues like tax superiority of PPF out of this article for now

• SBI Bond provides 9.95% interest and PPF provide 8%
• SBI Bonds provide simple interest , which means interest calculated each year would be returned to the investor , where as the PPF provides annually compounded interest  , which means interest calculated would be added to the principal and this new principal would be considered when calculating the interest for the next year 

So if you invest Rs.1,00,000 in the SBI bond , you would be earning Rs.9,950 each year so at the end of 15 years you would have earned Rs.1,49,250 ( 9,950 x 15 ) , so along with original invested amount , you would have Rs.2,49,250 

Now if the same Rs.1,00,000 was invested in a PPF , you would have Rs. 3,17,216.91 at the end of 15 years that is about Rs.68,000 more and this "more" is due to compounding . try the Calculator

Please also note that all returns from PPF is absolutely tax free and your initial Principal is also Tax Deductible under sec 80C , where as the entire return from the SBI bond issue is tax able.

This SBI issue is a good investment , i would recommend you to go ahead and invest , but please do not make the mistake of comparing the PPF with the SBI bond , as PPF is head and shoulder above all debt investment options that you have in the Indian market .

But also remember that compounding is double edged sword , that is, if you have a home loan, it is compounding that makes the amount you borrowed grow so quickly and by the time you close the loan you would have paid nearly twice or more the amount you had borrowed.

Compounding is something we learnt in class eight but, it may take us a lifetime to understand how powerful a tool this is .

In case you still did not understand how compounding works , try harder to understand it , make it your partner in investing and you would have no regrets.
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