Money matters: Power of Compounding vs Reducing Balance Effect

Two significant concepts in the vast world of money matters that shape the outcomes of our financial decisions are the Power of Compounding and the Reducing Balance Effect. Let us go on a simple journey where we investigate a scenario where there is a big loan and a Fixed Deposit (FD), both giving an interest of 8% over 20 years.

Understanding the Reducing Balance Effect on Loans

Think of borrowing ₹1.25 crore with an 8% interest rate for 20 years. This is where the Reducing Balance Effect comes in. Unlike flat interest rates, a reducing balance system will have interest calculated over the next balance as you repay the loan slowly but surely so that no matter how much has been repaid by anyone before others still owe. It resembles snowballing such that the debt burden progressively diminishes, which makes it appear as though it vanishes completely if one holds patience.

Here's a snapshot of how it works:

• Principal Amount: ₹1,25,00,000
• Period: 20 years
• Interest Rate: 8%

The reducing balance method calculates the EMI (Equated Monthly Instalment) in a way to cover both principal repayment and interest. The interest portion of the EMI also drops as the principal declines over time.

Let's break down the calculations:

• Monthly Interest Rate: 8%/12 = 0.667%
• Monthly EMI: Using the EMI formula,
• 𝐸𝑀𝐼=𝑃×𝑟×(1+𝑟) 𝑛 / (1+𝑟) 𝑛−1

Where P is the principal amount, r is the monthly interest rate, and n is the number of instalments (months).

𝐸𝑀𝐼 = 1,25,00,000 × 0.00667 × (1+0.00667)240 / (1+0.00667)240 – 1 = ₹1,04,601

The total interest paid over the 20 years can be calculated as:

• Total Amount Payable: EMI × 240 = 1,04,555 × 240 = ₹2,50,93,200
• Total Interest Paid: 2,50,93,200 − 1,25,00,000 = ₹1,25,93,200

Amortization Schedule

We'll show how the balance reduces in the first few months to illustrate the reducing balance effect.

Here is the breakdown of the EMI into principal and interest components for the first 12 months.

Explanation:

• Month 1: Interest is calculated on the initial principal (₹12,500,000). The EMI is ₹104,601, of which ₹83,338 is interest and ₹21,263 is the principal repayment. The remaining principal after the first EMI is ₹12,478,737.
• Month 2: Interest is now calculated on the new principal (₹12,478,737). The EMI is the same, but the interest component has decreased to ₹83,192, making the principal repayment ₹21,409. The new principal is ₹12,457,328.

• And so on...

As you can see, each month the interest portion of the EMI decreases while the principal repayment portion increases, leading to a gradually decreasing loan balance. This pattern continues until the loan is fully paid off over 240 months.

The Power of Compounding in Investments

Now, let’s shift focus and discuss investment. Think that you placed ₹1.25 crore in a Fixed Deposit that earns 8% interest. In this case, the Compounding Rule prevails. Compounding is a process where accumulated interest is reinvested in an additional interest-earning scheme for a person who wants to invest instead of spending it thus creating a money cycle that looks like a rolling snowball.

Let's see how it unfolds:

• Total Investment: ₹1,25,00,000
• Interest Rate: 8%
• Period: 20 years

Using the formula for compound interest,

𝐴 = 𝑃(1+𝑟/𝑛) 𝑛𝑡

Where A is the amount of money accumulated after n years, including interest. P is the principal amount, r is the annual interest rate, n is the number of times that interest is compounded per year, and t is the time the money is invested for.

Assuming the interest is compounded annually:

A = 1,25,00,000(1+0.08/1)20 = ₹5,82,61,964

The power of compounding results in an estimated value of Rs 𝑅𝑠 5,82,61,964 after 20 years.

Making Sense of the Story

The contrast between these two financial instruments is an intriguing one. Interest rate remains constant across both FD and loan products but the former has higher returns due to its compounding effect. It’s equivalent to sowing a seed and watching the tree grow with time.

Talking about the Reducing Balance Effect, repaying a loan becomes easier as the interest decreases over time. Conversely, the Power of Compounding is similar to an enchanting money multiplier which makes you have much more than what you initially had invested.

For example, in our hypothetical case of borrowing money, at the end of twenty years you will have paid interest in the amount of ₹1,25,93,200; while on the other hand, if you invest this money in Fixed Deposits your money will be converted into ₹5,82,33,636 demonstrating compound interest at its finest.

Practical Implications

Knowledge of these financial ideas assists in making better choices. In most cases, companies will go for loans while applying the reducing balance effect to manage their daily activities while still repaying their debts. Gradually paying such borrowed money will allow organizations to concentrate on other investments and operational activities as additional cash is gained. Conversely, someone having spare cash may make an investment aimed at improving their financial status through compounding interests.

In the end, understanding the interplay between compounding and reducing balance gives us the tools to explore the financial landscape wisely. Whether it is about taking a loan or choosing to invest, being aware of these concepts is crucial. It is a reminder that in the world of money, small decisions can have big impacts, and knowing the rules of the game can make all the difference.

By mastering these concepts, we can better manage our finances, achieve our financial goals, and secure our financial future.