Disadvantages of Compounding on Your Personal Finances
Power of compounding can hurt your investments and may work against your personal finances. We know very well the benefits of power of compounding for your investments. However, the compounding can also have negative consequences for your finances.
How Power of Compounding Can Hurt Your Investments?
Here we are going to discuss three scenarios in which compounding can work against you and can become your biggest enemy as far as your personal finances are concerned.
1. Interest on Loan & Credit Card
- In case of loans, the interest on the principal amount is charged by compounding it frequently over a particular period. Basically, compounding works when you earn the further interest income on the interest income reinvested earlier.
- In case of Investments, you keep the interest income reinvested to earn more interest income on it and make work the power of compounding in favour of you.
- However, when you have to pay interest on a loan or other credit facility, then compounding will work against you.
- If you look for the loan with longer tenure to reduce the EMI (Equated Monthly Installment), it is going to translate into higher compounding effect. Since you will be paying more as interest over the longer tenure.
When you use credit card and don’t pay off the entire amount by the initial due date, you are setting yourself up to pay compound interest. Here’s a very simple example showing how it works :
- You can see how adding the interest back to the balance and then charging interest on that new balance can add up quickly. The above case is oversimplified for the sake of understanding.
- You can get one thing clear that if you do not pay your dues on time, the interest that is due and unpaid will add up to the principal outstanding, And it also become eligible for interest payment, thereby increasing the outstanding amount exponentially.
- In this example, no payments are made, so the remaining balance continues to rise. In the practical scenario, you would make payments so the balance would decrease.
- It is important that one should know and make sure what the lender is charging and over what period.
Common Thought Process of People While Looking for a Loan
- Most people are aware of the cost of carrying unpaid balances on credit card and the burgeoning interest cost.
- However, in case of EMIs, people will still look for the lower EMI with longer tenure. They don’t think about the extra interest they will have to pay over the longer tenure of the loan.
- Thus the impact of compounding goes up depending upon the frequency at which the interest rate compounds.
2. Effect of Inflation
- Inflation is also an important parameter which damages your final investment corpus. The value of money reduces each year than the previous year by the rate of inflation.
- Thus, with each passing year, the purchasing power of the same money reduces in line with the inflation. For Example, 7% inflation means that you have to pay 175% more for the same expense in 15 years.
- Therefore, Inflation is the most critical parameter while investing for the long-term financial goals like Retirement planning, Children Education, Children Marriage etc.
3. Cost of Investments
- we can come across the negative side of compounding when you pay high costs, fees and taxes on your investments.
- By deducting these costs, fees periodically from your investment amount reduces sum of money that is actually invested and available to compound and grow over time.
- Over a longer investment horizon, the opportunity cost can have a significant impact on the final corpus. For example, a 2% annual cost paid over a 15-year period can reduce the final corpus by as much as 12%.
- Investments where tax is deferred to when it matures is more beneficial. It is because the returns are available to earn returns and compound till maturity. Investments such as bank deposits like fixed deposit, Recurring Deposit. where tax is deducted periodically, reduces the return that is available for compounding.
How to Make Compounding Your Friend?
- Time is the biggest parameter which determines the negative consequences the compounding can have on your finances.
- The longer the tenure for which you take a loan or don’t repay it, the greater will be the impact. So to reduce the impact of compounding, one should :
- Take a loan of shorter tenor
- Repay the loan on time
- Consider prepayment of loan
- Invest in a way that your money earns more than the rate of inflation so that the real rate of return is higher.
- Invest in products where the costs and fees are low and taxes are applicable at the time of redemption.
- Compound interest is great when it works in your favor in investments, but it can also be your biggest enemy when it works against you in loans and other debts.
- The key is to figure out how you can let it work in your favor. If you stay on top of your loan payments and always keep an eye on your investments, then compound interest can be your best friend when it comes to wealth.
- Having control of your personal finances makes it easier to navigate the road as you look towards the future.