This article will help you understand how to calculate the interest rate of your SIP investment. If you are a newcomer to the world of mutual funds, you will find this article helpful. It will touch upon the concept of SIP, the two main interest rate types, and the manner of calculating your historical SIP yield.
What is SIP?
Before proceeding further, let us understand the meaning of the term SIP.
SIP stands for Systematic Investment Plan. Investors deposit a certain sum of money regularly with a fund manager. In turn, the manager invests this sum into various financial instruments such as stocks, debt instruments etc. with the aim of getting good returns. The fund manager chooses those instruments which have a history of generating good yields in the past. In addition, they also look at the future earning potential of those instruments. Please note that every SIP fund is a basket of instruments. This means that the fund manager diversifies their investments in several instruments to maximize their yield while minimizing the attendant risks.
SIPs can thus be called an investment tool. Lately, SIPs have been the most preferred mode of investing in Mutual Funds. The reason being that with SIP offers multiple benefits such as tax benefits, wealth building, rupee cost averaging, etc. The selling price of the funds is more likely to register a profit, because in SIPs due to the regular payments, the buying price gets averaged in the market’s cycles of ups and downs.
An important consideration while choosing the right instrument is the rate of return or the interest rate. Stock markets and debt instruments perform differently from each other and hence, have varying returns.
Let us now understand the two different kinds of interest rates operating in the markets. This is important because your fund manager might have allocated a part of the corpus in various debt instruments which work on the basis of short and long-term interest rates.
Types of interest rates
1. Simple interest
This interest works in the case of debt instruments like Fixed Deposits. Interest is calculated on the principal amount and is added to the latter while redeeming the amount invested.
Let us understand simple interest with an example.
Suppose Rahul invests Rs. 10,000 in a Fixed Deposit with a bank for 365 days. The applicable rate of interest is 5%. At the end of 365 days, he gets an interest of 5% of 10,000= Rs. 500. The total amount that he gets back is Rs, 10,000+500=Rs 10,500/-
Simple interest rates may vary according to deposit periods. For example, when you invest Rs. 10,000 for 5 years, the interest rate might be 20% but when you deposit the same for 1 year, the rate might come down to 5% only.
Let us see what the interest is when Rahul invests Rs. 10,000 for 4 years @5%.
Here is the formula= 10,000x 5%x 4= Rs. 2,000
Thus, the formula for calculating the return on a simple rate of interest is: Principal X Rate X term
Rates can also differ across banks. One bank may offer a higher rate of interest on the same sum of money and period than another bank.
An important point to note is that your returns might be subjected to income tax if your salary or income falls within the tax bracket.
Please note that simple interest is charged in those cases where the element of risk is minimal. That is why Fixed Deposits are so much popular among risk-averse groups like retirees.
2. Compound interest
It is also called as ‘interest on interest’ and is calculated on the principal and the interest accumulated on a daily, monthly or quarterly basis.
For example, when Rahul invests Rs. 10,000 in a debt instrument that promises him 5% annual compound interest, then he can get:
a) Rs. 506.25 on a bi-annual compounding basis
b) Rs. 512.67 on a daily compounding basis or
c) Rs. 512.71 on a continuous compounding basis
As you can see, your yields vary according to the different interest rates. Yields are higher in the case of compound interest rate.
You can use this information to calculate your future yields if your fund manager plans to invest a part of your money in FDs.
Please note that interest rate movements are dictated by several factors such as the performance of the market or the investee organization, macro-economic reasons etc. In addition, the forces of demand and supply and supply also affect the interest rates.
How to Calculate your SIP Returns?
To calculate the overall returns on your SIP investment, we use a concept called XIRR. XIRR is a function provided by Microsoft Excel for calculating the annualized returns or internal rate of returns.
The inflows and outflows of cash may not be matched evenly and at times they could occur at irregular intervals. XIRR is helpful in calculating returns when the cash flows have irregular intervals.
While investing through SIP, you put in money at regular intervals over a period of time and generate wealth. These investments have a pre-set amount and are debited on a pre-set date. You are then allocated a certain number of units as per the day’s NAV of the scheme. Therefore, you keep amassing units since the start of your SIP investment.
When you decide to stop the SIP and redeem your investment, you get the amount generated over your investment period. That amount is calculated by multiplying the total number of units owned till date by the NAV of the scheme of the redemption date.
How to calculate your Investment return?
Having understood the two mainly used rates of return, let us now focus toward SIP rate calculation.
Your NAV is related to the performance of the stock market but this relationship may or may not be direct.
For example, the average rate of return if the Bombay Stock Exchange in 2017-2018 was 15%. But would your SIP yield be also 15%?
Not necessarily. Let us first consider the case of calculating returns on a lump-sum investment.
Absolute Return or Point to Point Return
Here, your return is calculated on a point to point basis.
For example, on April 1, 2017, your NAV stood at Rs. 25 but it rose to Rs. 35 on March 31, 2018.
In this case, your return was 35-25/25 x 100= 40%. You gained 40% in this period while the stock market performed just 15%.
A point to be noted here is that this SIP calculation is applicable to annual returns. But what if the investor wants to know about his performance over just 7 months and not 12?
To calculate your investment returns on an annualized basis, use this formula:
((1 + Absolute Rate of Return) ^ (365/number of days)) – 1
Let us go back to the case of Rahul whose NAV shoots up from Rs. 20 to 25 in 7 months or 210 days. Rahul’s absolute rate of return is 25%. What is his annualized return?
((1 + 25%) ^ (365/210)) – 1 =47.38%
Compounded Annual Growth Rate of Return (CAGR)
This method is used to calculate the return on your investment with a holding period over 1 year. Many investors park their money in funds for more than one year so this method can be used by them to determine their yields.
The formula is:
If your NAV was Rs. 20 three years back and now it is Rs. 40, then your CAGR would be:
To find your yield when the period is in months, the formula will be:
Please note that this method gives you the mean value of your yield over the years. It does not mean that your return was 25.99% every year.
SIP Plan Investment Calculator
These days, you can even calculate your future yields by simply putting your data in online calculators. For this, you can visit some of the fintech sites and do the needful.
The online calculator will ask for the following information:
a) Mutual Fund
c) Amount invested
d) Investment frequency i.e. Monthly, Semi-annual or annual
e) Start and end of investment dates
Once you enter this information, the calculator will ‘indicate’ your likely returns.
However, these figures are only indicative in nature; you never know how the investee companies are likely to perform in the near or medium term.
Systematic Investment Plans are those funds in which several investors contribute on a regular basis. This frequency can be weekly, fortnightly, monthly etc. The managers of these funds invest their corpus into several financial instruments like debt, equity, government bonds, bullion etc. Fund managers choose those instruments that can deliver the maximum returns with minimum risk. SIPs, also known as mutual funds and interest rates go hand in hand. There are two kinds of interest rates- fixed and compound. When you park your funds in a Fixed Deposit, your yield is calculated according to simple interest. In a compound interest scenario, interest is charged over the previous period’s interest. This way, your earnings can be amplified much more than in a simple interest linked deposit. Investors can calculate their historical SIP earnings in two ways- absolute and annualized methods. If you have begun investing recently and would like to know your potential earnings, then you can use several online calculators for this purpose. Interest rates are dependent on several factors like inflation, demand and supply, and the performance of the investee companies.