What they never tell you in school about the “Magic of Compounding” money !!

What they never tell you in school about the “Magic of Compounding” money !!

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Why am I so passionate about writing on financial independence for today’s young people? Because, somewhere deep in me is a feeling of responsibility on being part of a generation which frittered away the gains from what one could say is the most prosperous era in human history. Our fiscal profligacy has been the cause for many of our economic ills. Also, because in my view, our generation failed to pass on our traditional Indian values of simple, frugal and non-ostentatious living – which I  believe is also the main reason why our millennials hanker after immediate gratification despite the fact that, they face a more uncertain and volatile world than ours. It is critical that, we speak about money matters in the open.

In India speaking about Death, Sex and Money is taboo.

Which could explain why we are possibly the only English speaking country where human beings “expire” while elsewhere they die and only their driving license expires. We just don’t want to acknowledge death which is the reason, not more than 10% of us around 50 years of age have made a Will. Albeit, advertising campaigns driven by deep pockets in the insurance business have I believe, to a great extent been successful in getting us thinking about death.

Even sex is now playing out on our large movie screens that too in color. The recent release “Meri Sallu” seems to have thrust it into our face. The dreaded “S” word seems to be out of our closets.

However, “money talk” still remains confined in whispers. This taboo remains intact because talking about money especially about making more of it, is considered a corrupting influence on young minds. It is surprising to me because, even our scriptures promote business enterprise for the prosperity it brings, so long as it is legitimate and is conducted within the confines of morality. Irrespective, I believe our young should be equipped to handle their money for themselves or at least, to ask their advisors the right questions and to evaluate the answers they get in response.

Therefore, IF you have opened this post and do make it to the end – you are already half way down the road to financial freedom.

I say half because, whilst nothing in personal finance is difficult to understand (especially for our young and bright college graduates) in its conceptual sense; it’s the other half which demands time, patience and perseverance, that can prove a challenge.

But then ….. Whats this fuss around Compounding ?

Did we not mug up that “Compound Interest “ formula in primary school?

In my view, therein lies the problem – because, whilst all of us were taught how that formula is derived and even as most of us solved numerous mind twisting exercises; no one was ever explained its practical application in the day to day personal finance. However, unlike in primary school, with technology having made our lives simpler and we now have MS Excel to demonstrate that easily for us.

In this post, I only wish to address the need for you to fully appreciate the ability of “Compounding” to magically convert the “small” (which is what they are most likely to be when you are starting off in life) amounts you can save into size-able wealth and on the other hand, show how that magic could turn around to work against you like Witchcraft!

Sam Ro (Managing Editor @Yahoo Finance) puts it across so well.

 “Compound interest occurs when the interest that accrues to an amount of money in turn accrues interest itself. It’s the deceivingly simple force that causes wealth to rapidly snow ball. This is why it’s the concept that is at the core of all finance. The longer you wait to start saving for retirement, the more you miss out on the benefits of the incredible power of compound interest.” 

Obviously, for the Magic of Compounding to work it needs (1) persistent saving at regular intervals (2) patience, as its Time who is the magician here and (3) income (it could be interest, dividends, stock market returns) earned has to get reinvested over and over again.

Let me forewarn you that, all this is not going to be painless – but Hey! Ever heard of “No Pain – No Gain”? But once that snowball gets rolling, you are firmly on path to wealth.

So, don’t let anyone tell you that, even a Rs 500 which you saved from your first pay cheque is too small for you to begin saving with – it would be utterly against your own longer term interests to wait till you have a big pot of gold to begin saving.

Keep reading this Blog and given time and execution, you will prove them all wrong.

As I said, Time is the magician and the young are fortunate to have plenty of it. This is what the legendary investor and world’s richest man, Warren Buffet has to say: “I always knew I was going to be rich, so I was never in a hurry to”.

How boring? Yes!! Whoever told you that, making money was exciting as though it were an adventure sport?

Well now lets look at how the Magic in Compounding impacts you.

It is very beneficial when you are an investor but on the other hand, it brings along severe downsides when you are a borrower.

Lets begin with the good part i.e. the effect compounding has on your investment accumulations.

The above graph clearly demonstrates the huge difference between Simple and Compound accruals  – I know its a no brainer but it does come out quite starkly here.

Even with accumulations in relatively small amounts, the differences are significant.

Graph 1: The Rs 1 lakh invested (from Age 21 to 65) @ a constant return of 5% pa., gives Rs 6.13 lakh more when the returns are reinvested.

Graph 2: Rs 10,000 invested every month (from Age 21 to 65) @ a constant return of 5% pa., gives a whopping Rs 92.48 lakh more.

However, the most significant observation should be about, how large Rs 10,000 invested monthly (returns reinvested) can get – Rs 2.13 Crore.

CLICK HERE: Understand interactively The Magic in Computing 

As with earlier posts, all the Excel Sheets attached have also been kept open. I have also attempted to guide you through the process so as to enable you understand the formulas.

LETS LOOK AT ACCUMULATIONS – OR SAVINGS and understand the interplay between “Time” & “Compounding.” For this we will use the Excel financial formula for ‘Future Value’ (FV) , which calculates the future value of an investment given a constant rate of return.

CLICK HERE: to see the impact of Time & Compounding on your Savings

Clearly the biggest learning here is that, there is a HUGE cost of delaying your savings plan – especially for “retirement” . The benefits of staying invested over long periods of time and reinvesting the income earned, can be enormous.

The difference in starting to invest ( at constant return 10.5% pa) with a monthly amount of Rs 10,000 at age 35 years, instead of 25 years is Rs 4.55 Crore and about an additional Rs 1.5 Crore if you were to begin at 45 !!

Therefore, the earlier you begin saving, (albeit a smaller amount) the earlier will you gain your financial freedom.

HOWEVER, COMPOUND INTEREST WORKS AS WITCHCRAFT – AGAINST YOU WITH EQUAL VIGOR WHEN ITS ACCRUING ON A LOAN BORROWED !! 

CLICK HERE: to know more about the impact of Compounding on Debt

I should confess that, I am not a great fan of loans which to me is like spending the money which you “may” earn in the future. Personally, I did take home mortgage loans but never have I borrowed money for short term goals, especially of those involving discretionary consumption e.g. a holiday. I would only take a planned holiday which  meant, saving the money with a Short Term Goal (Holiday) before it was spent.

Personal Debt and its management, is a topic important enough to dedicate a post or even two – but that is for later.

The significant downside of compounding in debt, makes it very important for you to appreciate this aspect just as well as you did its benefits. If we are not careful, borrowing, especially high cost debt like credit card; has the potential of severely denting your financial stability. Unsecured debt (i.e debt not secured by an asset like a vehicle or house) can attract interest anywhere from 15% to 21-23% on credit cards.

If you have noticed, in our savings example we have assumed a return of 10.5% per year which is quite ambitious if one was to assume an inflation rate of 5.5% resulting in a “real return” of 5% per year. Therefore, how expensive is the 23% interest on credit cards!

We can get the following learnings from the above (Impact of compounding on debt) Excel Spreadsheet:

Worksheet (1) EMIs & Balloon Payments: Even when the rate of interest & Loan amount are the same; with an increase in the “Frequency of EMIs” (from Yearly to Half Yearly to Quarterly and Monthly repayments) the repayment begins earlier and therefore reduces the interest paid by a borrower. Naturally, the amount eventually repaid by the borrower too is lesser. The balloon payment (in our example, its assumed to be Rs 2 Lakhs) pushes the repayment till after the last EMI is paid and hence the interest paid by the borrower is naturally higher.

Therefore, always start paying your EMIs earlier. Think carefully before, reacting to a car or property dealer’s advertisement that screams ” No EMIs till possession”. The interest will accrue and compound for the entire period and added to your purchase price or the loan, if it has already been disbursed .

Worksheet (2) EMIs on increasing loan periods: As the loan maturity is pushed further away, the EMI gets smaller and the interest paid by a borrower increases substantially. 

This happens firstly because, interest increases as the period of the loan lengthens ( the risk becomes higher as the repayment extends more and more into the future) and secondly because, the compounding snow ball this time, is rolling rapidly down hill straight in your face.

Fast Loan Approvals with Lowest EMI” is one of the oldest dirty tricks used by shifty real estate and car salesmen aided by aggressive bankers to exploit the aspirations of gullible folks, by pushing them into buying assets which would have normally been beyond their threshold of affordability. Most borrowers are focused on the EMI and its affordability in terms of their pay cheque and in the process, one ends up paying a lot more interest, at higher rates and over a longer period of time. Therefore, whilst the salesmen and bankers achieve their sales targets and earn a bonus, you my dear friends will have pushed away your financial independence a few years ahead.

Needless to say, this would escalate asset maintenance costs too!. High gearing can prove lethal during times of high interest rates and/or when we have to bear the brunt of personal emergencies.

Therefore, always remember no one is doing you a favor by reducing the EMIs on your loans.

Worksheet (3) How much can I borrow? This is a corollary to the EMI learning – for a constant EMI, we can borrow a higher amount (subject to credit worthiness) as the period to repayment goes up.

Its important to appreciate that, whilst Compounding is indeed a simple arithmetical concept, we should never under estimate its power to severely impact the pricing of the loans we borrow. One should be particularly careful with large ticket borrowings like home mortgages. Its worth taking the trouble to understand and evaluate the alternatives, product variations beyond their ad-captions and jingles.

 

Don’t ever forget that, there is never a free meal (that is if there ever was such a thing) in finance !

The concluding part in the series on ‘Budgeting’ (i) Why and how should we automate the “savings process”  (ii) Why should we create and invest an “Emergency Fund” and (iii) How to manage those dreaded “month end” liquidity shortfalls …………………… before we move on to the slightly more esoteric topic of Identifying our Life Goals & Develop a Life Plan.


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