The benefits that compounding brings to investments are well-known. But what is not commonly known is the fact that compounding can sometimes work against you too and can have negative consequences for your finances. We tell you three scenarios in which compounding can work against you.
Interest on loans
Compounding works when you allow the interest income you get to earn further interest income. In investments, you do this by letting the interest income you have already earned remain invested to earn more returns and this works to your advantage. But when you have to pay interest, say on a loan or other credit facility, then compounding will work against you.
Looking for a loan with a longer tenure to reduce the equated monthly instalment (EMI) will translate into a higher compounding effect since you will be paying more as interest over the longer tenure. If you do not pay your dues on time, the interest that is due and unpaid will add up to the principal outstanding and also become eligible for interest payment, increasing the outstanding amount exponentially. This is what happens to your credit card outstanding or when you miss an EMI due on a loan.
“Most people are aware of the cost of carrying unpaid balances on credit card and the burgeoning interest cost. But with EMIs, they will still look for the lower EMI with longer tenor without thinking about the extra interest they will pay over the longer term of the loan," said Dilshad Billimoria, director, Dilzer Consultants Pvt. Ltd, a financial planning firm.
The impact of compounding goes up depending upon the frequency at which the interest rate compounds. Credit cards, typically, use daily compounding and this pushes up the effect of compounding on the payment due.
Inflation and its impact on the value of money is another way compounding eats into your corpus. Each year reduces the value of a sum of money from the previous year by the rate of inflation. The way this manifests itself is the reduction in what a fixed sum of money can buy with each passing year or the amount of money to meet an expense goes up with each year in line with inflation. For example, a 5% inflation means that you have to pay 107% more for the same expense in 15 years.
“People are able to see that money is able to buy less over time. But their ability to prepare for it is not as effective, especially when it is a recurring goal like retirement. Most people consider inflation at the start of retirement but overlook the fact that the impact of inflation on income will be felt through retirement years. They are quite shocked when they see what inflation does to their retirement corpus," said Billimoria.
Cost of investments
The flip side of compounding is also seen when you pay high costs, fees or taxes on your investments, which reduces the sum of money that is actually invested and available to compound and grow over time. Over a long investment horizon, the opportunity cost can have a significant impact on the 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 because the returns are available to earn returns and compound till maturity. Investments such as bank deposits, where tax is deducted periodically, reduces the return that is available for compounding.
What you should do
Time is the biggest factor that determines the negative impact that compounding can have on your finances. The longer the period for which you take a loan or don’t repay it, the greater will be the impact. So take loans of shorter tenors, repay them on time and even consider prepayment to reduce the impact of compounding.
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.