That’s right. You just need to think of the bank as an investor. For the bank, a loan is an investment that it earns interest (return) on.
You take a loan of Rs 50 lacs at 9% p.a. for 20 years. It is a bullet repayment loan. You pay the entire amount at the end of 20 years. No payments in the interim. To close this loan, you will have to pay Rs 2.80 crores after 20 years.
On an investment of Rs 50 lacs, simple interest would have been only Rs 4.5 lacs per annum or Rs 90 lacs over 20 years. The remaining 1.4 crores = Rs 2.8 crores – Rs 50 lacs (principal) – Rs 90 lacs (simple interest) comes from interest on interest. This is compounding, isn’t it? Just that it is not working in your favour this time around. Since you are the investment (and not the investor) in case of a loan, the power of compounding can be said to work in the reverse.
In fact, just by paying interest of Rs 37,500 of interest per month for 20 years and no principal repayment, you could have limited to loan repayment outgo to Rs 1.4 crores (Rs 37,500 X 240 + Rs 50 lacs of principal). By not paying any interest for 20 years, you let the interest compound.
A bank is the investor in a loan. By delaying receiving the interest, the bank has let it compound. And if it is good for the bank, it can’t be a good for you (unless you can make an investment that gives you more than 9% p.a.). By the way, don’t grudge the bank its income. It takes some risk in lending to you.
How Do You Wrest the Power of Compounding in a Loan?
Simple. By paying your EMIs. Let’s take an example.
You take a Rs 50 lac loan at 9% p.a. for 20 years. However, instead of a bullet repayment, you pay this loan by way of EMIs. EMI will be Rs. 44,986. At this rate, you will pay Rs 1.08 crores. Even though the bank took Rs 58 lacs extra, Rs 1.08 crores is still a substantial cut from Rs 2.80 crores.
Why did this happen? The magic is in the way the EMIs work in reducing balance loans. Each month, you pay the complete interest for the month and anything left is used for principal repayment. Therefore, there is no unpaid interest left to compound at the end of every month. Since the complete interest is paid on a monthly basis (that’s how EMI based reducing balance loans work) and principal also goes down by some amount, the loan does not compound. Essentially, the monthly interest payments arrest the power of compounding.
By paying an EMI every month, you brought down your total outgo over 20 years from Rs 2.8 crores to Rs 1.08 crores.
As we have seen in earlier posts, prepayments can also bring down the total amount you pay to repay the loan. However, that has nothing to do with compounding.
As an Investor, What Is the Lesson for You?
To be honest, this is more of an academic exercise. The banks don’t give long term bullet repayment loans. For some short-term loan products such as gold loans, bullet repayments are permitted but such loans are exception. Compounding (interest rate) is anyways not a big problem for short term loans. Most loans are EMI based. Therefore, interest does not compound against you. However, for that, you need to stick to the repayment schedule. If you do not pay your EMI as per schedule, the power of compounding (in reverse) will start rearing its head. Interest will be charged even on the unpaid interest.
In case of credit card or even other loans, there may also be a penalty which can add to your problems. And these penalties can be quite heavy. Interest is charged even on these penalties. Therefore, it is important that you make your scheduled loan or credit card payments.
By not making payments on time, not only does your loan burden increase but this impacts your credit score too. With a poor credit score, you will find it difficult to get a loan in the future or you may get it at a higher rate of interest. It is not difficult to understand that not paying your debt on time can lead to problems. The concept of compounding puts a mathematical perspective around it. These unpaid penalties and interest can move you closer to a debt trap. As I have always maintained, don’t take a loan unless you can afford it.