How compound interest works – for you and against you?

Compound interest is a powerful thing. If done well, the compounding machine can work wonders for your life. If not, compounding can work against you.

Compound interest is a double edged sword, and its output can vary vastly based upon little difference in inputs (typically savings & spending habits) in long run!

The idea of this post is to illustrate, how can some savings do wonders to your life – thanks firstly to the savings, and increasingly over time to compound interest.

How compound interest works - for you and against you?

Example of how compound interest works – for you or against you!

(This assumes Indian context, but is applicable elsewhere also, with few tweaks in numbers and percentages!)

Suppose a family has an income of Rs. 100,000 a month. And let us assume that the couple is currently 30 year old. They have been spending the entire money in day to day expenses, and are living quite comfortably. They live well, stay at a good apartment, eat out once or twice a week, party occasionally, take vacations once a while, indulge in retail therapy once a while and so on.

By the end of the month they are looking to get the paycheck again.

Not a super-luxurious life, but quite comfortably well off.

One fine day they had 2 chance encounters – one with the Frugal couple, who are trying to save for the future and spend less (and hoping to achieve financial independence/ F.I.R.E) and second with the stylish couple who live life luxuriously, spend well, party well and have recent bought a sedan on EMI. (And are also paying an EMI for the vacation they took last month!)

And surprisingly, they get impressed by both (at least a face value) and decide to make changes into their life.

Which direction?

They debated.

….

Here are the two routes they can take:

The frugal way

They decided that they’ll save Rs. 10,000 every month now on. This can be done by reducing eating out to twice a month (from once/ twice weekly), buying new clothes once a quarter rather than monthly, watching movies in morning shows (which are cheaper) and taking public transport as far as possible.

With this, they figured out that they’ll be able to save Rs. 10,000 a month.

The lifestyle upgrade route

Another thought was that they ought to live a better lifestyle .So maybe they can get a better car, party more often, go for more branded clothes and so on. They figured out that this will require Rs. 10,000 additional per month. which is not difficult to finance – they can always get car loans and personal loans.

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Next they projected, how much will saving money save them money over a 25 year time period. (when the couple will be around 55, and closer to retirement)?

And how much splurging in lifestyle will cost them?

Simple arithmetic told = Rs. 10,000 X 12 months X 25 years = Rs. 30 Lac.

But the answer  was not just simple arithmetic.!

The answer lies in how much the saved and invested money would become over a 25 year time period. And how much interest they’ll end up paying while taking loans to fulfill all lifestyle need?

 

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Here were the results of their hypothetical lifestyle changes:

If they saved Rs. 10,000 every month for 25 years they would save NOT Rs. 30 Lac … But close to Rs. 94 Lac, assuming 8% rate of returns (Which one can get by investing in debt instruments like PF, PPF, liquid funds, debt fund, bank deposits etc. at current rate of interest)

If they invest in a mix of debt and equity, and get returns at 12% per annum (close to historical rate of returns if one uses a mix of debt and equity) they can get nearly Rs. 1.8 Crore (equities carry a risk of lower returns also, but have historically done well over long term horizon)

This is an example of compounding working for you!

On the other hand, if they borrow and spend additional Rs. 10,000 per month they’ll end up spending nearly Rs. 1.3 Crore additional. Of this nearly 1 Crore is interest (subtracting Rs. 30 Lac which is the simple total of the amount saved).

(Of course, this will require taking higher loans to service existing loans, and more and more interest payments which are not sustainable in long run and banks will probably stop giving them loans after some time. But hope it explains the idea of compounding working against you well!)

This is an example of compounding working against you.

 

Calculation –  Compounding working for you @ 8%

Compounding working for you @ 8 percent

Compounding working against you

Calculation –  Compounding working for you @ 12%

Compounding working for you @ 12 percent

Calculation –  Compounding working against you @ 10%

Compounding working against you @ 10 percent

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In long run the amount your save (and invest/ borrow (and repay) is not just simple sum total of amount saved/ borrowed.

This money can compound into a humongous amount altogether!

 

 

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Disclaimer – The assumptions about savings rate, rate of returns & interest you pay is simplified to drive a point. The rate of returns, loans you take, EMI you pay etc. will vary over long run. And so will human behavior! 

Things may NOT follow a similar pattern in real world. 

This presents an India specific scenario. Different countries will have different interest rates, and expected rate of returns

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