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.
Image : FreeDigitalPhotos.net,Photographer: graur razvan ionut

How is PPF interest not calculated

How is interest calculated on a PPF account ? This has been a mystery and if you google you will find all kind of answers and based on the answers, people try to find the most efficient way to use their PPF account

A couple of ways in which PPF interest is not calculated

• It is not compounded monthly
• It is not calculated only in the month of March

Here is my take ,
Interest in a PPF account is calculated each month . Please note the stress is on calculated not credited .

Each month the least amount in the account between the 5th and the last day of the month is used for calculating the interest and 12 such calculations are done and finally in the month of March , the 12 interests are added together and  credited as interest for the year.

This is something unique ,

• This is not monthly compounding, though interest calculated so, as the interest amount is still not credited hence not considered for the next month's interest calculations
• Neither is the interest calculated only in the month of March , though interest is credited in March .

This means if you think crediting your money in March, is the best way to do so ... you are wrong , as in that case your would earn interest only for the month of March

You want to take full advantage of the PPF interest calculation ? then, deposit as much as you can in the month of April and if you can , before 5th of April ...that would be a smart move

Image : FreeDigitalPhotos.net,Photographer: jscreationzs

Exponential growth

The Graph that you see is a how your money would grow in a PPF account.

 If you invest Rs.70,000 each year , this is how your money would grow to about 20 Lakhs at end of 15 years.

You would come across lots of article on power of compounding and also calculators that would calculate for you the final amount . But like the saying, a picture speaks a thousand words , only when you see it as a graph you see what compunding actually does to your money.

As you would see the graph is not linear , but Exponential

In nature during any epidemic and massive outbreak of infections and diseases , it is found that the microbes have started mutiplying exponential to reach gigantic proportions quickly and similarly when fraudster want to increase the reach of their schemes , they try to build Mutilevel Marketing and Pyramid Schemes , since all these help them to grow very very fast.

On the graph , if a line was drawn joing the top of each of the bars , it would increasingly get steeper and steeper , which means larger and larger returns , so the most important factor then would be "Time" ...you give enough time for your investments that is growing exponentially and you would see your returns grow to gigantic proportions

PPF as Retirement Planning tool

I have started seeing PPF , as part of the bigger picture and would request readers to do that . Yes , contributions to the PPF , help you save tax as part of 80C . But if you see PPF from the context of retirement planning , that would be a great tool too. PPF could be your debt component of the retirement planning along with may be Pension plans,MF,Direct equity exposure , which form your equity component of retirement planning .

What better instrument to be in for retirement planning , then something which could compound your contributions over 15 year period to start with and which can be extended to keep compounding until you retire .

You will find people who say that, Equity exposure , would be the most appropriate way for retirement planning , i would not disagree , but feel that PPF would de-risk to some extent your retirement corpus

Why do people do not invest in PPF

I would consider PPF as one of the finest avenues of investment , especially as one of the strategies to achieving your retirement planing goals along with any pension plans,MFs and direct exposure to stocks that you may have

I have spoken to quite a lot of people about this and found these are reasons that people generally have avoided or do not have a PPF account

Do not even know there exits something called PPF
People know that compounding is an amazing way to make your money work harder , they know it is something which works wonders when seen from an long term prespecive.Yet you ask them about instruments available in India , which will allow them to compound their investment , you will suddenly encounter a silence.

Money gets locked in for 15 Years
This true ,yes of course you can avail loans and all those , but I would believe for real benefit of PPF to be availed , you would need to let the money be there for 15 years. and if you look at PPF as part of your retirement strategy , you would not feel that lock-in of 15 years is a disadvantage , but rather something that just help you accumulate your retirement nest.

Government can change the Interest rate any time
This true , PPF interest rates have changed from the time I had opened my PPF account . but times have changed , it is the age of coalition government and end of single party rule and hence would consider that going forward , it would not be so easy for governments to tamper with PPF interest.So may be we start taking advantage of these uncertain political times to build our PPF account.

So would recommend that your open up your PPF account today , if you still do not have one and if you do have one start maximizing your contribution towards your PPF. unlike a ULIP , which hugely rewards the agents there are no such incentives for an PPF agent , hence this product is rarely recommended or aggressively promoted