How compounding can work against you?

Compounding can work wonders for your financial life.

But, there is a catch.

This assumes that you are prudent and wise with your money. Unfortunately, most of us aren’t. And this is a perfect way to make compounding work against you.

How compounding can work against you?

Let us understand with the following example

How much you end up paying when you take a debt, say a car loan?

Suppose you decide to buy a car for Rs. 10 lac and Finance them that and that’s how much money do you actually end up if the interest rate is 10% spread across 5 years?

  • You’ll end up paying over Rs. 12.75 lac (approx). And this is for something that depreciates in value.
  • That additional 2.75 lac, if invested, (@ 55k per year) could have grown to at least 3.5 lac even with conservative fixed deposit rate of returns.

Can you see the difference?

Let us consider a variation of this scenario: (since, car may be a necessity for you!)

Suppose you have Rs. 5 lac in your bank account and want to buy a car. There are 2 options

  1. Buy a car worth Rs. 5 lac – All cash.
  2. Buy a car worth Rs. 10 lac – 5. lac cash and 5 lac via car loan. The car loan at 10 percent for a 5 year tenure will cost nearly 6.4 Lac.

At the end of 5 years you’ll probably have:

  1. Case 1 – You have a car worth nearly Rs. 2.5 Lac (50% of initial cost)
  2. Case 2 – You have a car worth Rs. 5 Lac (50% of initial cost), and have paid nearly Rs. 6.4 lac in servicing the debt.

(You can use any online EMI calculator to get the above numbers!)

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This can be true for most of the loans – personal loan, gold loan, home loan, credit card debt and so on. The math isn’t too hard to do. And you may realize that compounding is working against you, primarily due to 2 factors –

  1. The additional money you end up paying.
  2. The opportunity cost – The compounding your “saved” money could have undergone.

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It doesn’t take a rocket science to know the power of compound interest – how it can work for or against you.

Stay out of debt and you make compound interest work for you. Make debt a part of your life and you make compound interest work against you.

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