Mutual Funds

What do you mean by dividend policy?

Dividend policy of a company is the decision about the distribution of dividends to its shareholders. Dividend policy is a financial decision that involves deciding on the dividend payout ratio, the frequency of dividends and should they pay dividends at all or not.

The dividend decision of a firm depends on the profits, investment opportunities in hand, availability of funds, industry trends in dividend payment, and company’s dividend payment history.

Profits: Dividend payment is made from the profits of the company. If the company has no profits, then the company won’t be able to pay dividends.

Investment opportunities: If the firm has projects that will lead to the expansion and growth of the company, then the company would prefer retaining back the profits to fund the new projects.

Availability of funds: A firm’s availability of funds impacts the dividend decision. If the firm has enough retained earnings to fund new projects, then they have enough funds to distribute dividends from the current year’s profits.

Industry trends in dividend payment: A company has to keep up with the industry’s dividend payment to survive. Else the shareholders might liquidate their shares in the company to invest in competitors companies.

Company’s dividend payment history: A company that is paying regular dividends tends to keep the dividends stable over the years. They either keep the dividend payout ratio steady or the dividend amount stable.

What are the four types of dividends?

Following are the four types of dividends that can be a part of a company’s dividend policy:

Cash Dividend: Cash dividends are the most common and popular form of dividend payouts. The company issues a dividend to all shareholders. The cash dividend amount is deposited into the bank account of the shareholder as per their shareholding.

Stock Dividend: Through stock dividend payouts, a company issues additional shares to its common shareholders without any consideration. When a company issues less than 25% of the previously issued stocks, then the dividend is treated as a stock dividend. On the other hand, when the company issues more than 25% of the last issue, it is referred to as stock split.

Property Dividend: A company sometimes issues a non-monetary dividend to its shareholders. The issue of property dividend is recorded against the current market price of the asset issued. The market price of the asset can be either higher or lower than the book value. Therefore, in the company records, the transaction is recorded as either a profit or loss.

Scrip Dividend: In a scenario where the company does not have enough dividend, it may issue a promissory note. A promissory note that is indicating to pay dividends at a later date. Essentially, this creates note payables for the company.

What is the difference between a cash dividend and a stock dividend?

Dividend-paying companies often pay shareholders cash as a percentage of the share price. A cash dividend is a regular cash payment by a company to its shareholders. The money that the company issues as a dividend is often a percentage of free cash that it doesn’t use for any investment.

On the other hand, stock dividends are in the form of more company shares. For example, when a company announces a 10% stock dividend, it means that an investor with 100 shares is eligible to get ten shares as a stock dividend. Therefore, the investor will now have 110 shares.

Cash dividends are taxable. At the same time, stock dividends are subject to tax only when the investor chooses to turn around and sell the extra stocks for cash.

What is the difference between the interim and final dividend?

An interim dividend is a dividend that a company pays during the financial year before the company’s Annual General Meeting (AGM) and releasing the financial statements. On the other hand, the final dividend payment is after the declaration of financial results.

Board of directors declares the interim dividend and shareholders declare the final dividend in the AGM.

Retained earnings is the source for paying the interim dividends. Current earnings is the source for paying final dividends.

Interim dividends are related to a part of the financial year, usually six months. Whereas, final dividends relate to the full financial year.

The Board declares interim dividend only when the Articles of Association of the company permits them to. Whereas, final dividends are the right of the shareholders, and there need not be any explicit provision to declare final dividends.

Once the company declares interim dividends, there is no debt obligation on it. The company can cancel the interim dividend after the declaration. However, once the company declares the final dividend, it cannot cancel it. Also, there is a debt obligation on the final dividend.

What is the benefit of dividend stocks?

Dividend-paying stocks are profitable to shareholders in two ways. They offer capital gains through capital appreciation and also additional income through dividends. Also, they provide consistent income through dividends. Dividend-paying companies are usually cash-rich and strong companies that have good prospects for long term performance. Additionally, dividend-paying stocks are less vulnerable to volatility.

Twofold benefits: Dividend-paying stocks offer two-fold benefits to its shareholders. Firstly, shareholders benefit from long term capital appreciation. Secondly, they offer additional income to their shareholders. This also enhances their investment portfolio as the dividend reinvestment can generate more returns.

Consistent income to shareholders: Dividend-paying stocks provide consistent income to its shareholders. This helps them to earn additional income to the shareholders.

Strong companies: Dividend-paying stocks are cash-rich. They are strong companies and have good financials. It also gives confidence to the shareholders about the prospects of the company.Low volatility: Dividend-paying stocks usually belong to sectors whose performance don’t wholly depend on economic cycles. Hence these stocks are less vulnerable to market volatility.

How often do dividends payout?

Most companies pay dividends every quarter (four times a year). They often pay upon declaring their quarterly account. However, dividend payout frequency may vary from company to company. Some companies may pay every six months (semi-annually) or annually or no set schedule (irregular dividends).

Company’s earnings are paid as dividends to the stockholders. In simple terms, investors earn for owning the stock. For dividend payouts, the following are the four important dates to remember:

Declaration date: It is the date when the Board of Directors of a company declare their intention to pay a dividend. For accounting purposes, the company on this day creates a liability in its books. It now owes the money to its shareholders. On this day, they also announce the date of record and payment date.

Date of record: The date of record is the date on which the company reviews and determines who the shareholders are. An investor has to be the ‘holder of record’ to be eligible to receive a dividend payout. The shareholder on or before the ex-dividend date will receive the dividend.

Ex-dividend date: Ex-dividend date is an important date for dividend investors. To be eligible for dividend payouts, an investor must purchase the shares of the company prior to the ex-dividend date.

Payment date: It is the date on which the dividend is given to the shareholders of the company.

What is a dividend payout policy?

A company’s dividend payout policy is the decision about the distribution of the company’s profits to its shareholders. A dividend payout policy of a firm is a financial decision that involves decisions on dividend payout ratio, and the frequency of dividends.

The dividend decision of a firm depends on the profits, investment opportunities in hand, availability of funds, industry trends in dividend payment, and company’s dividend payment history.

Profits: Dividend distribution happens from the profits of the company. If the company has no profits for that financial year, then the company will not be able to pay dividends.

Investment opportunities: If the firm has expansion plans that would lead to the growth of the company. Then the firm would retain back the profits to reduce the cost of funding the new projects.

Availability of funds: The availability of funds will affect firm dividend policy. If the firm has retained earnings that would fund the new project, then the firm will be able to distribute dividends despite having new projects in hand.

Industry trends in dividend payment: A company has to keep up with the industry’s dividend payment standards to survive. Else the shareholders might liquidate their shares in the company to invest in competitors companies.

Company’s dividend payment history: A company that is paying regular dividends tends to keep the dividends stable over the years. They either keep the dividend payout ratio stable or the dividend amount stable.

What are the four types of dividends?

Following are the four types of dividends:

Cash Dividend: Cash dividend is the most popular and common form of dividend payout. The company issues a dividend to all shareholders. The company deposits the dividend money into the bank account of the shareholder as per their stock holdings.

Stock Dividend: Stock dividend payout is when the company issues additional shares to its common shareholders without any consideration. When a company issues less than 25% of the previously issued stocks, then the dividend is a stock dividend. On the contrary, when the issue is more than 25% of the last issue, it is a stock split.

Property Dividend: A company can always issue a non-monetary dividend to its shareholders. The issue of property dividend is recorded against the current market price of the asset under consideration. The market price of the asset can be either higher or lower than the book value. The company, therefore, records the transaction as either a profit or loss in their books of accounts.

Scrip Dividend: In a scenario where the company does not have enough dividend, it may pay dividends by issuing the promissory note. The promissory note that is indicating to pay dividends at a later date. Essentially, this creates note payables.

What is an annual dividend?

Dividends are the share of retained earnings and profits that a company pays out to its shareholders. The company either distributes the profits to the shareholders or reinvests it in the business. The frequency of dividend payout largely depends on the company. Most companies pay dividends every quarter, while some pay semi-annually or annually or do not follow a set schedule (irregular dividends).

The total value of dividends paid by a company to investors in a year is the annual dividend. In other words, the annual dividend is an indicator of per share or aggregate of dividends paid to the shareholders during a year. The annual dividend per share, divided by the share price determines the dividend yield.

What is the difference between the interim and final dividend?

The interim dividend is the dividend that a company pays during the financial year before the company’s Annual General Meeting (AGM) and releasing the financial statements. The Board of Directors declare the interim dividend and pay it out of retained earnings. Interim dividends are related to a part of the financial year, usually six months. The Board declares interim dividend only when the Articles of Association of the company permits them to. Once the company declares interim dividends, there is no debt obligation on it. Moreover, the company can cancel the interim dividend after the declaration.

The final dividend is paid after the financial results are declared. The shareholders declare the final dividend in the AGM, and the company pays it from current earnings. Final dividends relate to the full financial year and are the right of the shareholders. There need not be any explicit provision to declare final dividends. Once the company declares the final dividend, it cannot cancel it. Also, there is a debt obligation on the final dividend.

Should I buy a dividend ETF?

Dividend ETFs are a type of Exchange Traded Funds that invest in stocks with a potential to offer a high dividend. These are passively managed funds and track a particular index. An individual doesn’t need to worry about managing the funds themselves. Dividend ETFs best suit investors who are looking for high yields and more stability from their investment portfolios.

Most ETFs offer quarterly dividend payments; however, some also offer monthly dividend returns. Therefore, investors looking for a monthly income stream can consider dividend ETFs as one of their investment options.

Furthermore, it is important to look at the track record of the stocks that the ETF invests in. Also, some dividend ETFs have a high expense ratio. Hence it is important to consider ETFs with the lowest expense ratio or no-load mutual funds. No-load mutual funds are the ones that one can buy and sell without any commission or charges.

Dividend ETFs are suitable for risk-averse investors looking for a regular income. Also, beginners can consider investing in dividend ETFs as they may lack the knowledge and time to understand the market.

Is it better to buy an ETF or stocks?

Exchange Traded Funds (ETFs) are passively managed investment options. The fund manager focuses on identifying, buying and selling the units in the portfolio. They employ diverse investment strategies to generate significant returns for their investors. Also, dividend ETFs provide regular income for their investors.

On the other hand, stocks are the most volatile type of investments. An individual must have good knowledge and understanding of the stock market while investing. Also, one should be able to take buy and sell decisions before it’s too late.

ETFs are a good diversification tool that helps in reducing volatility in the investment portfolio and mitigating risk. The choice of ETFs or stocks completely depends on the investors profile, their willingness and understating of risk, etc. ETFs offer advantages over stocks when the returns from the stocks in a sector have a narrow dispersion around the mean. Also, ETF investments are advantageous when an investor is unable to gain an advantage through knowledge of the company. Stocks can generate significant returns; however, they have a significant amount of risk attached to them as well. Higher the risk, higher the returns.

Therefore, ETFs and stocks suit different types of investors, and it is a personal investment style that dictates.

What are the disadvantages of ETFs?

Exchange Traded Funds have the following disadvantages:

• Demat account is required
• Stock exchange-based transactions
• Market returns
• Large-cap portfolio

Demat account required: To invest in ETFs one requires a demat account. And one has to pay a certain fee every year to maintain a demat account.

Stock exchange-based transactions: All ETF transactions are facilitated by stock exchange (except NFO). Hence to redeem their units, investors will have to sell it on the stock exchange. And the liquidity of the ETF will depend on the volume of the transactions on the stock exchange.

Market returns: ETFs replicate an index. Hence the returns are limited to the market returns. On the other hand, actively managed funds strive to generate excess returns over the benchmark.

Large cap portfolio: In India, most of the ETFs track major indexes like Nifty and Sensex which are large-cap indexes. There are very few investment choices in mid and small-cap ETFs. Mid and small-cap companies tend to outperform large caps in a bullish market.

Are ETFs good for the long term?

ETFs offer a fresh alternative to bond and stock investments. ETFs, combine well-known benefits of stocks and bonds diversification, tax efficiency and lower costs. Additionally, ETFs require lower minimum investments.

ETFs are ideal for long term investment provided that one invests in the right ETFs. They are not suitable for an investor looking at fast buy-and-sell for the stocks. Over the long term, ETFs have the potential to generate significant returns. Therefore, the longer one stays greater is the potential to generate higher returns.

Furthermore, dividend ETFs provide an additional regular source of income over the long term. Additionally, they offer good portfolio diversification, high portfolio turnover and segmented investing strategies at lower fees.

ETFs suit almost any investor. Long term investors looking to save for retirement can also invest in ETFs. The longer the time horizon, the greater is the opportunity for growth. Also, post-retirement, one can invest in ETFs to help them offset inflation and have a regular source of income (through dividend ETFs).

Is it better to reinvest dividends or get cash?

When an investment pays a dividend, an investor has two options to choose from. The investor can either choose to use the cash as a source of extra income or invest the same back. Having an extra source of income is appealing; however, reinvesting the same will pay off in the long term.

Reinvesting the dividend is a good strategy as it is very cheap. One need not incur extra costs of investing if they opt for dividend reinvestment. Once one opts for reinvestment, it gets automatically processed every time one receives a dividend. Every time the dividend is reinvested, the average cost of investing goes down. This will help in boosting returns.

One can always opt for taking cash when the underlying asset performing poorly or one needs an additional source of income. Also, when the reinvestment leads to an unbalanced portfolio, one can consider taking cash instead of reinvesting the dividend. Additionally, one can take cash when they plan to diversify their portfolio by investing the same in a different asset class. Otherwise, it is wise to reinvest dividends rather than taking cash.

What is debt in simple words?

The definition of debt is ‘an obligation that requires the debtor to pay the money to their creditor.’ Debt is nothing but the amount of money one borrows. In other words, it is the money one spends that isn’t theirs. For example, taking a loan from a bank, making credit card purchases, etc. Large corporations also borrow money to finance their projects and for other business needs.

The most common types of debt are loans and credit cards. In addition to these, corporate borrowings are known as corporate debt. Also, bond and commercial paper are the common types of corporate debt instruments that are not usually available to individuals. Bonds are a type of debt instrument that enables a company to raise funds by selling the promise of repayment to its investors. On the other hand, a commercial paper is a short term debt instrument with a maturity of 270 days or less.

A debt agreement is an agreement that permits the borrowing party to borrow money with an obligation to pay back at a later date, usually with interest. Moreover, one perceives debt as a negative concept. However, with proper planning and management, one can benefit by taking debt to meet their requirements.

What is the difference between loan and debt?

Loan and debt are terms often used interchangeably due to the reason that they both primarily mean borrowing money. However, there is a small difference between the two. A loan is money borrowed from a lender. On the other hand, debt is the money raised through the issuance of bonds or debentures.

A loan is money one borrows from a lender. The lender can be a bank or a financial institution. Moreover, a loan is more structured in terms of payment, and the principal amount is paid back to the borrower in instalments over a period of time. Also, loans are usually taken by people for their personal uses. However, even companies take loans to run their businesses.

The definition of debt is the money that the company raises through the issuance of bonds and debentures. Governments, companies, trusts, or corporations can issue bonds to fund their business, and the lender, in this case, will be the investor. The investor will receive interest payment regularly until the bond or debenture matures. Also, upon maturity, the investor gets back the entire principal amount in lump sum.

What is the difference between stock and securities?

Securities are investments that are easily convertible to cash. On the other hand, stocks are one type of securities. Some of the other types of securities are bonds, ETFs, futures and options, banknotes, real estate, etc. Most securities trade on the exchange or in the secondary market.

Stocks are securities not different, just that stocks are a type of securities. Securities are broadly classified as ownership securities, debt securities and derivative securities. Ownership securities are stocks. Debt securities are notes and bonds. Derivatives securities derive value from the price fluctuations or changes of other securities or commodities.

A stock is one type of security that belongs to the equity class. An investor would always invest across multiple securities to have diversification to their portfolio and to address volatility (risk). Investing in just one asset class like stocks would lead to high fluctuations in the portfolio returns. On the other hand, having investments across different securities will help in generating good returns in all market scenarios.

Stocks represent an ownership interest in a company; on the other hand, securities like debt allow the borrower to borrow funds, derivative securities for hedging or speculative purposes.

What are the types of security?

Security is a financial instrument. Different parties trade securities in the open market. Following are the four different types of securities:

Equity Securities

Equity refers to stocks and shares. It represents the ownership interest held by shareholders in a company. The earnings of a shareholder are usually in the form of dividends. Also, listed equity securities are volatile and are the prices rise or fall as per the market conditions.

Debt Securities

Debt or fixed income securities represent that the money is borrowed and shall be repaid with interest upon maturity. These securities include government bonds, certificate of deposits, corporate bonds, treasury bills etc. These are bought and sold with a promise to repay the same with interest. Also, the debt agreement predetermines the rate of interest, the amount borrowed, the maturity and renewal date.

Derivative Securities

The value of derivatives securities depends on the underlying asset. The underlying asset can be stocks, bonds, interest rates, market indices, interest rates, or goods. It is a contract between two or more parties. Where the value of the investment is derived from underlying financial assets. The main purpose of derivatives is to minimise risk. One can achieve it by insuring against the price fluctuations. The different types of derivatives are future, forwards, options, and swaps.

Hybrid Securities

Hybrid security is a type of security that has both debt and equity securities characteristics. Many institutions use hybrid securities to borrow money from investors. Examples of hybrid securities are convertible bonds, where the bondholder can convert to equity stocks during the bond tenure or at maturity. Preferred stocks, these allow the holder to receive dividends prior to common stockholders.

What are the 5 components of credit score?

One can calculate their credit score using the following 5 components

• Loan repayment history
• Credit Utilisation Ratio (CUR)
• Credit mix
• Duration of credit
• Number of credit enquiries

Loan repayment history

The loan repayment history of an individual affects their credit score. A credit information company keeps track of all payments towards loans, bills and EMI. One single non-payment or late payment can drag down the credit score by 100 points.

Credit Utilisation Ratio (CUR)

CUR measures the usage of available credit in the credit card. The more the ratio, higher will be the reduction in the credit score of an individual. Ideally, the CUR should be below 30% to maintain a good credit score.

Credit mix

The type of credit mix impacts an individual’s credit score. A healthy mix of secured and unsecured loans will help in maintaining a good credit score. Having too many unsecured loans might drag the credit score down.

Duration of credit

Duration of a credit line is one of the components of credit score. Older the loan, better the credit score as it shows the individual’s responsibility to the creditors in making timely payments.

Number of credit enquiries

The number of credit enquires affect the credit score. Individuals themselves make soft enquiries, and that doesn’t affect the score. However, lenders make hard enquiries after a legal permit is obtained. Too many enquiries might show the individual is credit hungry and might drag the credit score down.

How does a corporate bond work?

A corporate bond is a type of fixed income security issued by corporations or companies to raise money from investors. The company issuing the bond gets the capital they need, and in return, they pay the investor interest. Upon expiry of the bond, the company pays back the money to the investor.

When a corporate bond is issued, the investor will become the lender, the company issuing the bond will become the borrower. Most of the time, the company’s ability to repay is taken as collateral. One can assess the ability to repay through future revenues and profitability. In some cases, the collateral can be the firm’s physical assets.

An investor need not worry about assessing a firm’s financials before investing in a corporate bond. Every corporate bond is rated by credit rating agencies. The rating agencies like CRISIL rate the bonds from AAA to Default, with AAA being the highest rating. A AAA corporate bond is considered to be very safe, and the risk of default is almost zero. The interest rate of AAA bonds is less when compared to the bonds rated below it.

What is the risk of corporate bonds?

Corporate bonds are fixed income instruments. The company borrows the money from investors and pays them interest until the bond matures. Upon maturity, the company pays back the principal amount. There is a risk that the company might default on the payment. Additionally, during a rising interest rate regime, the value of the corporate bonds fall. Therefore corporate bonds are prone to default or credit risk and interest rate risk.

Credit risk

Corporate bonds are rated by credit rating agencies. The bonds rated AAA are considered as safe as the risk of default is almost zero. However, as the rating falls, the risk of default increases. Hence to compensate for it, the bonds having lower credit rating have a higher interest rate.

However, there is no guarantee that bonds that have a high rating might not default on payments. Hence there is always an element of credit risk present in all corporate bonds.

Interest rate risk

Corporate bonds are long term debt securities. During the tenure of the bond, the interest rates in the market keep changing. In a rising interest rate regime, the value of the corporate bonds fall. This is because, when the interest rates rise, the opportunity cost for the investor for holding these bonds increases. The investor might be able to get a higher interest rate for the same value of the bond. Therefore to compensate for that, the bond prices must fall.

When the interest rates rise, investors automatically switch to bonds paying the higher interest rate. Hence the value of the existing bonds fall. The investors will face trouble in selling the low value bonds against the new attractive ones in the market. Additionally, the market value of the bonds held by the investor may go below the initial purchase price, leading to losses for the investor.

Are corporate bonds safer than stocks?

Corporate bonds are a type of debt securities issued by public and private corporations. The main purpose of issuing them is to raise money to meet the business requirement. When an individual buys a corporate bond, they are lending money to the issuer (company) of the bond. As a result, the issuer promises to return the money on the predetermined maturity date and interest rate.

On the other hand, stocks are equity instruments. A stock is also known as a share. It is ownership security. In simple words, stocks are shares of ownership in a company. The company doesn’t have any obligation to issue a dividend to the stockholder.

Stocks do not earn regular income or interest income like corporate bonds. The gains from stocks are when the company issues dividends or upon sale (when the market price of the share rises in comparison to the initial buy price). Share prices are subject to market volatility and hence are considered to be riskier than debt securities.

Bonds are good investment options for portfolio diversification. However, it is important to note that corporate bonds have the credit or default risk and inflation risk associated with them. The issuer may default their payments resulting in loss to the investor.

What are the disadvantages of bonds?

Following are the disadvantages of corporate bonds:

• Risk of losing money
• Interest rate fluctuations
• Lower returns than long term equities

Risk of losing money

Companies issue corporate bonds, and they might default on payments. In case of default, the bond investors will be considered first for payment, and they might get only peanuts. Hence there is always a risk of losing the investment.

Interest rate fluctuations

During interest rate fluctuations, the value of the bond will fluctuate too. If the interest rates rise, the bond might seem unattractive to investors, and the value of the bond will fall drastically. The investor might face a problem selling the bond in the secondary market.

Lower returns than long term equities

Corporate bonds are long term investments, and the returns from them might not match the returns from investing in equities for the same tenure. Equities have the potential to give higher returns in the long term. For the same tenure, these debt securities might not give similar returns.

What are the advantages of corporate bonds?

Following are the advantages of investing in corporate bonds:

• Higher returns
• Tax efficiency
• Liquidity
• Tenure and Coupon structure

Returns

Corporate bond funds may generate higher returns. The investor by investing in them is undertaking significant risk when compared to other government bonds. Therefore, the higher the risk, the higher are the returns. Moreover, these bonds have a higher growth potential than government bonds.  Additionally, the companies also make regular coupon payments to their investors.

Tax efficiency

Corporate bonds are long term investment options with durations for more than three years. Therefore, investing for three years will have a tax advantage. These funds are taxable at 20% with indexation benefit. Hence, investors falling under the highest tax bracket may benefit from this the most.

Liquidity

Most corporate bonds trade on the secondary market. In other words, one can buy and sell these securities even after their issue. Therefore, an investor can sell if the bond prices increase or buy when the prices fall.

Tenure and Coupon Structure

Bonds have different maturities. For example, there are long term, medium term, short term, and perpetual corporate bonds available for investors to choose from. Similarly, bonds have different coupon structures. An investor can choose the coupon structure that best suits them. For example, fixed-rate, floating-rate and zero-coupon bonds.

Which is better compounded daily or annually?

Compounding means earning interest on interest. It doesn’t matter when the investor receives the interest. However, the number of compounding periods do make a difference. The more the number of compounding periods, the higher will be the interest generated.

If the interest is compounded daily, then the number of compounding periods is 365. This means the interest will earn interest every single day of the year. However, in the case of annual compounding, then the compounding period is just one. Hence the interest earned can be less in this case.

Let’s understand this better with an example.

An investor, Ms Shika, invests INR 50,000 in a savings scheme that offers 10% interest. Her tenure of investment is three years. Let’s see the value of her investment at the end of 3 years in both cases.

On the first day in both cases, the interest for Ms Shika would be INR 13.69 (50000*10%/365). On the second day, in case of daily compounding, the interest would be calculated on INR 50,013.69. This is because the interest will earn interest in daily compounding. However, in the case of annual compounding, the interest for a day throughout the year will be INR 13.69. This is because the interest calculation is on INR 50,000 for the entire year. At the end of the year, the interest calculation is on INR 55,000 (50000+13.69*365).

At the end of 3 years, in case of daily compounding, the maturity value of the investment would be INR 67,490.16726. And in case of annual compounding, the maturity value would be INR 66,550.

The difference between the maturity value of daily compounding and annual compounding is INR 940.16. Hence, daily compounding is better than annual compounding due to higher number of compounding periods.

Is simple or compound interest better?

Simple interest is the interest one earns on the principal. One can calculate it by simply multiplying the principal amount with the interest rate and tenure. Compound interest formula is based on the principal and interest that is accumulated in every compounding period. Simple interest formula is easier to understand than compound interest formula. However, when it comes to investing, an investor will benefit more from compound interest than simple interest.

Let’s understand it better with an example. Mr Akhil is an investor who invests a sum of INR 10,000 for a period of 5 years. The interest rate offered to him is 10%.

In case of simple interest, Mr Akhil will earn an interest of INR 5,000. The total value of his investment at the end of 5 years is INR 15,000. Using the compound interest formula, the interest amount will be INR 6,105.1. The total value of his investment at the end of 5 years is INR 16,105.

Hence one can earn higher interest in case of compound interest. Therefore compound interest is better than the simple interest in case of investing. However, when one is borrowing, simple interest is better as the interest payment will be lesser.

What is compounded annually?

Compounded annually implies the interest is compounded at the end of the year. In other words, the interest will earn interest at the end of the year. During the rest of the days, the interest will be calculated on the principal amount.

Let’s understand this better with an example. An investor wants to invest INR 20,000 in a savings scheme that offers a return of 12% for a tenure of 3 years. The compounding of interest is done annually.

The investment will start earning interest right from the first day of investment. So on day 1, the interest would be INR 6.57. For the next 364 days, the interest calculation on the principal amount and will be INR 6.57. At the end of the year, the value of the investment would be 22,400 (INR 20,000+(6.57*365)).

From the second year, the interest calculation is on INR 22,400 instead of INR 20,000. Hence the interest will earn interest only at the end of the year. By the end of the third year, the value of the investment would be INR 28,098.56

Is credit card interest compounded daily?

Yes, the credit card interest is compounded daily. Credit card interest calculation is on daily based on the average daily balance during the statement period. However, the interest charges are waived if the balance is paid off before the due date.

Credit card interest calculation is on the average daily balance with daily periodic rate and the number of the days in the billing cycle.

The interest calculation is irrelevant if one is paying off their credit card dues on time. The interest calculation is done during the grace period. Grace period is the time between the statement closing date and the due date. To avoid paying interest, one can pay off their credit card dues on time.

Who benefits from compound interest?

A person who lends or invests the money will benefit from compound interest. Compound interest will help in increasing the pace of money growth. This is because the principal and the accumulated interest earn interest. This creates a snowball effect, and both the investment and interest grow together.

A lender would benefit from compound interest, while a borrower will have to shell out more interest. However, in an investing scenario, an investor would benefit from compounding. The more the number of compounding periods, the higher will be the accumulation of wealth.