We all want to save for
our long-term financial goals. However, these goals can be achieved by not one,
but combinations of different asset classes (equity, debt etc) which will help
us accumulate the desired corpus. It is also a fact that different asset
classes may also differ in terms of returns and safety. Some of these
investment avenues could be fixed income instruments while a few others may be
market-linked in nature. Public Provident Fund (PPF) remains a popular
fixed-income investment backed with a government guarantee on the principal and
interest earned. What’s more, even the earnings are tax-free!
What works most in the
favour of PPF account is its tenure and the way compounding of the interest
income happens in the scheme. PPF is a 15-year scheme and the compounding is on
an annual basis. Had Source 39 the tenure been short, the effect of compounding
would have got lowered and with no compounding over a long term, the effect
would have been minimized too!
Compare compounding in
life insurance transnational plans such as endowment or money back to PPF. In
the former, there is no compounding even though those plans are of long term
and the bonus declared gets attached to the policy yearon-year. The next year
bonus is not declared on the accrued amount but only on the original sum
assured. In PPF, the interest earned in a year gets added to fund and next year
interest gets accrued on the previous year basis. Over time, this approach
creates wealth even with little or no fresh contributions. We will how it
happens later on.
Impact of compounding
in PPF
In a way, long tenure
and the feature of annual compound in PPF complements each other well. Let’s
see how compounding impacts PPF corpus after working out the numbers using a
PPF Calculator. We assume the PPF interest rate is 8 per cent per annum
throughout the 15-year period. On investing Rs 1.5 lakh each year, the maturity
value comes to about Rs 44 lakh – where Rs 22.5 lakh is the principal invested
and nearly Rs 21.5 lakh is the interest earned, nearly 48 per cent is the
interest! Now, let’s suppose one invest Rs 1.5 lakh each year only for the
initial ten years and then invest only Rs 500 for the last five years to keep
the account active. The maturity value comes to about Rs 34.5 lakh, of which 56
per cent is the interest! The amount of interest earned in the last five years
is nearly Rs 11 lakh on a total additional contribution of Rs 2,500. This is
possible because of the effect of compounding as interest declared earns
interest on each year’s balance amount.
The above is just an
example to show the impact of compounding in PPF. Do not merely consider PPF
for tax saving purpose. Ideally, maximise the contributions if you have
investible surplus even while maintaining asset allocation. One can even extend
the PPF account indefinitely with our without making fresh contributions after
15 years. Even after several decades, PPF remains a dependable investment to
create a tax-free wealth over the long term.
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