Economics

Compounding Interest: Friend or Enemy?

05/09/2016

The word compounding interest often makes us anxious, especially to people with debts. We often hear that people got entwined with debts as they wrongfully predicted the consequences of interests. However, on the other hand, interests could be a big advantage if we see it from the perspective of an investing investor.

Then why do compounding interests often come off as terrifying to borrowers? If we are taking an example, a person borrowed Rp 1 million, with an interest of 1 percent per month. If we assume that the person does not pay installment at all, after one year, the debt of such person will become Rp 1.126 million or equal to an interest of 12.6 percent a year. Even if in such example, it is assumed that the interest is 2 percent per month, in a year, the debt of such person will become Rp 1.268 million, or with an interest of 27 percent per year.

It is quite interesting from the abovementioned example that if we are being offered investment products with return guarantee of 27 percent, we might become pessimistic. With all bad news about bulging investment, we are often suspicious of investment products that give promises of profit above 25 percent. However, on the other hand, we are often not thinking twice when we borrow with interests of 2 percent per month, or almost 27 percent per year.

Nonetheless, what is being shown above is not in any way implying that borrowing with the basis of interests is somewhat taboo. If we take the abovementioned example, whereas a person owes Rp 1 million, with interests of 2 percent per month. But, such person pays installment fee of Rp 94,560 per month. Therefore in 12 months, such person will repay all of his/her debts along with the imposed interests. The total payment done by such person for a year is Rp 1.134 million. Therefore, such person was imposed to effective interests of 13.4 percent, not 27 percent as being illustrated above in a scenario where such person did not pay installment fee at all.

From the example above, it is clear that borrowing in the form of compounding interests is not something taboo. But, the indiscipline of a person in paying installment fee could make such person entwined in huge debt as the consequences of interests. Often the person entwined with debts blame the interests aspect and stated that they are surprised by such scheme too. Compounding interests have been found and implemented since thousands of years ago, firstly in the Babylon era. Therefore, this is not something new at all.

The logic behind compounding interests is truthfully quite simple and fair. If it is assumed that a person borrowed Rp 1 million and promised to pay interests of 2 percent. One month later, the person lending the money reserves the right of Rp 1.02 million. Consequently, if it is returned by the borrower, the lender could turn Rp 1.02 million with the chance of consideration from the capital of Rp 1.02 million, not Rp 1 million. Therefore, if the borrower do not repay the loan by the end of the first month, on the second month, it is just for the borrower to be imposed 2 percent of interests from Rp 1.02 million instead of from Rp 1 million.

Compounding interest could be seen as terrifying if it is illustrated from the perspective of a borrower. However, on the other hand, if it is illustrated from the perspective of an investor, compounding interests may quickly give rise to a person’s investment value. Same as the example above, where the value of effective interests drop when installment fees are made, the profit from the investment will grow fast with the concept of interests, especially if the investment is done for long term without performing any withdrawal.

If a person invested with a profit of 5 percent per year, the Rp 1 million invested for 10 years will become Rp 1.63 million. If the profit of such investment is 10 percent per year, at the end of 10 years, the investment value will become Rp 2.59 million. However, if it is assumed that the person withdraw Rp 30.000 from their investment each year, even with the consideration of 10 percent per year, at the end of the tenth year, the investment value of such person will only reach Rp 1.8 million, or 30 percent lower than in the scenario where the investor does not make any withdrawal from their investment. So, it can be understood that interests can quickly give rise to investment value, especially if there are no withdrawals made in the period of investment.

It is clear that each person has to be able to manage his/her financial position so he/she can do a long term investment. From the example above, we may conclude that the profit of interests is deeply affecting the person who conducts long term investment, without having to make withdrawals. On the other hand, for borrowers, they have to manage disciplined installment fee payment so that their debts will not increase due to compounding interests. Lastly, the concept of compounding interests may be a friend, or an enemy. It all depends on how you manage your finance. For undisciplined borrowers, the concept of interests could be a deadly enemy. On the other hand, for disciplined investor, the concept of interests sounded like beautiful music as they can give rise to investment value swiftly.

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Important Information:
The views and opinions contained herein are those of Teddy Oetomo, Head of Intermediary, and may not necessarily represent views expressed or reflected by PT Schroder Investment Management Indonesia (“Schroders Indonesia”) view. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders Indonesia does not warrant its completeness or accuracy. This does not exclude or restrict any duty or liability that Schroders Indonesia has to its customers under Indonesian laws and regulations.

"PT Schroder Investment Management Indonesia (PTSIMI) had received an investment manager license from, and is supervised by the Indonesian Financial Services Authority (OJK).”

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