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Compounding the ERROR
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In any financial transaction, it is important to know the interest and return rates.
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GRANTED, YOU are thrifty. You do count all the paise that pass through your hands. But do you know when money due to you does not come to you?
It is amazing the way people ignore the power of compounding of interest rates, whether on deposits or loans. The concept is often not understood, and if is seldom regarded with seriousness. Whether you buy a house, use a credit card, invest in a stock, bond, or mutual fund, the effect of compounding can vastly change the economics of your decision. It may be difficult to believe, but its effect can often make the difference between financial success and failure.
Let us compare the two in a simple transaction to realise the importance of compounding.
One way to see the importance of compound interest is to look at what happens when interest is compounded. When a bank advertises that interest rate is compounded, it usually shows the stated rate and the effective rate. For instance, a rate of six per cent per annum compounded for one year, at quarterly intervals, has an effective rate of approximately 6.136355 per cent. While 0.136355 per cent doesn't sound like much, it means an extra Rs. 136.35 per Rs. 1,00,000 per annum. Not impressed? For Rs. 1,00,000 deposited in a bank for five years, the difference in interest would amount to Rs. 4,685! And if the interest rate is higher, the difference gets significantly larger. For instance, in the example stated above, if the interest rate were to go up by a third from six per cent to eight, the difference would go up by over 83 per cent to Rs. 8,595.
Let us now take the case of loans. Many people do not realise the impact of the period of a loan. Suppose you take a loan of Rs. 1,00,000 with an interest of eight per cent, and choose to pay it over five years, your monthly payments would be Rs. 2,028.
Thus, you would pay a total of Rs. 1,21,680 of which Rs. 21,680 would be interest. If you go for a 10-year period, at an interest rate of eight per cent, your monthly payments would be Rs. 1,213. This means that you would pay a total of Rs. 1,45,560, including Rs. 45,560 as interest. If you decide on a 15-year mortgage at the same rate, your monthly payments would add up to Rs. 1,72,080, of which the interest component would be Rs. 72,080. A total sum of Rs. 2,00,640 will have to be paid to liquidate the loan in 20 years in monthly instalments of Rs. 836. The interest overtakes the principal!
In any financial transaction, it is important to know your rates. Interest and return rates are key to all financial considerations. To pass off even the slightest difference as unimportant can be a costly mistake.
KUBERA
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