Borrowing vs investing: When debt destroys your compounding power

The concept of compounding stands as a cornerstone of wealth building. It refers to the process where an investment earns returns not just on the initial principal but also on the accumulated gains from prior periods.

This mechanism creates exponential growth, turning modest sums into substantial assets over time. For instance, an investment of Rs 1 lakh will grow to Rs 3.10 lakh over 10-year period if it earns 12 percent per annum. It will compound to Rs 9.65 lakh over 20 years.

Further, regular investment of Rs 1 lakh every year earning 12 percent p.a. will compound to Rs 17.55 lakh over 10 years; over 20 years it will grow to Rs 72 lakh.

Even more remarkably, investing just Rs 1.4 lakh each year could accumulate Rs 1 crore in 20 years.

The Dark Side: Debt’s reverse compounding

Yet, this same force can turn adversarial when applied to debt. Borrowing introduces a reverse compounding dynamic, where interest accrues on unpaid balances, eroding wealth rather than building it. Debt comes in various forms, categorized by interest rates and purposes, each carrying different risks.

High-interest debt: A wealth destroyer

High-interest debt, such as credit cards or unsecured loans, is particularly damaging.

Consider a credit card debt of Rs 1 lakh with a monthly compounded interest rate of 3 percent. If you pay 5 percent of the outstanding balance each month, it will take 32 months to reduce the balance to Rs 50,000. By that time, you’ll have paid a total of Rs 1.2 lakh, with Rs 70,000 going towards interest alone.

Alternatively, paying 5 percent of the initial loan monthly clears it in 31 months but costs Rs 1.55 lakh, including Rs 55,000 in interest. As Rohit Beri, CEO and CIO of ArthAlpha said, “This derails your journey to financial independence and invites bankruptcy at worst.”

Instead of servicing such debt, redirecting those funds—say, Rs 5,000 monthly—into equity mutual funds could grow to Rs 1.80 lakh after 31 months.

Low-interest debt: Handle with care

Low-interest debt is a double-edged sword that demands caution. It can facilitate asset acquisition if used wisely, but Beri cautions that it can rapidly become a financial burden if not managed carefully.

Also read | Avoid these credit card mistakes before they cost you

Borrowing for expenses: Financial suicide

Borrowing for everyday expenses is especially hazardous, regardless of the rate. Using loans to fund lifestyle choices like gadgets or vacations creates a cycle of dependency. What starts as affordable can escalate, as missed payments trigger penalties and higher rates. Beri said, “This is a sure shot path to financial suicide, urging individuals to live within their means and avoid personal loans for non-essentials.”

Leveraging for investments: High-risk gamble

Investing with borrowed money amplifies risks further. Leverage might seem appealing when returns appear promising, but markets are volatile. A Rs 1 lakh personal loan at 16 percent for speculative trades, like futures and options, could vanish in losses, leaving you to repay over two years at Rs 5,000 monthly—totaling far more than borrowed.

Beri advises against this, pointing out that investment returns are not guaranteed, but interest and principal repayments are mandatory. Margin trading or loans against securities for IPOs should be avoided, as they pit uncertain gains against fixed liabilities.

Also read | Buying a home? Learn these home loan terms before you sign

Borrowing wisely for home

“Borrowing for a home is the only exception to the rule of avoiding debt, but it comes with certain conditions,” said Beri. To qualify, the interest rate should be reasonable, falling under the low-interest debt category.

Additionally, you’ll need to have saved a substantial down payment of 20 percent or more. Your monthly cash flows should also be robust enough to cover the EMI payments with some buffer to accommodate potential increases in the future.

It’s essential to note that this exception applies only when the property is for personal residence, not for investment purposes, as real estate returns may not keep pace with mortgage costs in the current inflation scenario.

Key takeaways

Ultimately, the interplay between borrowing and investing hinges on discipline. Prioritize debt elimination, especially high-interest varieties, to harness compounding’s full potential.

By steering clear of leverage for speculative or consumptive purposes, individuals can align this powerful force with long-term prosperity rather than peril. In a landscape where financial missteps compound quickly, informed choices preserve and accelerate wealth accumulation.