Public Provident Fund: How power of compounding works best in PPF; All you need to know

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Updated: August 13, 2019 3:13:38 PM

Public Provident Fund (PPF) remains a popular fixed-income investment backed with a government guarantee on principal and interest earned and what's more the earnings are tax-free too!

PPF Calculator, Public Provident Fund, PPF account, PPF interest rate, fixed-income investment, PPF compounding, compounding, Saving for goals, PPF tax-free, PPF tax savingWhat works most in the favour of PPF is its tenure and the way compounding of the interest income happens in the scheme.

We all want to save for our long-term financial goals. However, these goals can be achieved by not one, but a combination 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 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 minimised 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 year-on-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.

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Impact of compounding in PPF

In a way, long tenure and the feature of annual compounding 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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