Albert Einstein once famously said that compound interest is the most powerful force in the universe. He said, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” He also said that compound interest either work for you or against you. The choice is yours.
If someone uses it to his/her advantage it will make a huge difference over the long term. Long term should be considered as something like 15-20 years and not five years or so. While almost every one of us have read about compound interest in our schooling days the concept of compound interest is not so intuitive.
When the recent loan deferment guidelines were announced by RBI many people were in a dilemma to take it or leave it. Somehow people assumed that if they don’t pay their three installments their tenure would be extended by three months. So they were in shock when they read Economic Times article like this one which said that if you miss two installments then you will have to pay 10 installments over and above the two installments they miss out.
The best way to explain the reason behind it is that the two EMIs which are not being paid have been postponed by the loan tenure. These delayed EMIs have been parked aside and the normal loan continues. The installment against delayed EMIs start once the normal loan tenure has ended. Hence each installment becomes equal to six installments after 19 years assuming 9% rate of interest. Hope this helps to explain why decision to not pay installments for two months could add another 10 installments apart from the two in the long run.
The same situation also gives a great silver lining. If someone is capable of paying two extra installments, then he can save 12 installments in future. This is how compounding can work in your favour.
Compounding and its application in Real Estate
So now that we have some understanding of compounding let us try to see how can we benefit from it. One place where compounding works beautifully is real estate. Real estate investment is typically a long term investment with huge investment. The two most important factors for compounding to make a significant difference is:
- Amount invested
- Long investment tenure
The rate of interest which is the most cited number can create huge difference even at low values if these two conditions are met. Hence banks earn a lot even at low interest rate from home loan customers because real estate loans have high loan amount and the investment tenure is long.
Obviously a higher rate of interest will make huge difference but the lender earns a significant amount even at these lower rates. Hence banks and financial institutions want to us to take long loans (20 years -25 years) and dissuade us from making any prepayment.
How to make compounding work in your favour
Let’s create a comparable case study of two investments in real estate and assume two friends want to invest Rs 15 lakh in real estate. Let’s also assume that they can pay Rs 25,000 per month from their pocket in addition to the rental income from the property. The summary of the investment will be as follows:
|Scenario||Option I||Option II|
|Total Purchase value||55,30,000||44,30,000|
|Net rental income||12,000||10,000|
|Self-contribution per month||25,000||25,000|
|Actual EMI||₹ 37,075||₹ 35,045|
|Tenure (basis of EMI)||18.8||11|
|Loan outstanding after 10th year||27,04,396||4,00,738|
In Option I the instalment paid is Rs 2,000 higher than compared to second case. Still he needs to take a loan of almost 19 years compared to 11 years in Option II. Now let us see how principal repayment compares in both the options.
Option I and Option II comparison
|Month number||EMI||Interest paid||Principal paid||Outstanding principal||EMI||Interest paid||Principal paid||Outstanding principal|
- The principal repayment difference is around 6,000 per month at start
- The gap of principal repayment increases to almost 10,000 per month by end of fifth year
- The gap of principal repayment increase to almost 15,000 per month by end of tenth year
- The loan outstanding is Rs 27 lakh for option I compared to Rs 4 lakh for option II by the end of tenth year
The compounding is working much more in favour of option II than option I. The scenario implies that final price difference in option I needs to be Rs 23 lakh higher than option II to give same returns. This means that if the price of Rs 50 lakh unit rises to Rs 1 crore but if price of Rs 40 lakh units rises to Rs 80 lakh then also its better to buy the Rs 40 lakh unit.
- While it’s hard to guess the property values after 10 years it is much easier to determine the cost over the next 10 years.
- Moreover, after 11th year in Option II, flat would be free from any encumbrance (loan) while flat bought under Option I will be encumbrance free only after another eight years.
- Once repayment is done the investment in Option II will generate rental income and support the investor
- This may help the investor to go through any downturn in his financial conditions or property prices
- Hence an investment of lower tenure helps a real estate investor manage the market conditions much better
- It also helps to reduce the cost and make compounding work in his/her favour
- Since a long term loan makes compounding work in the favour of financial institution, a banker would always offer the highest possible loan tenure to customers
- Hence one needs to understand how compounding works before investing in real estate and try to make it work in his/her favour
About the author – Abhishek Kumar Choudhary is a finance professional with keen interest in real estate. Abhishek has worked with investment banks, developers and also runs his own startup. He is a graduate of IIT Bombay and currently works with a real estate firm.