Most of us borrow money because we have been conditioned into thinking that assets can be bought ONLY by borrowing. So telling a 29 year old not to borrow for her car, or telling her boyfriend not to borrow for his motorbike costing close to half a million is futile. They will borrow, and they do think that they know the cost of borrowing. Oops wrong.
Interest costs are easier to appreciate ONLY when you understand OPPORTUNITY costs. What is opportunity cost?
If you had an opportunity to earn Rs. 5000 for running an errand, and you missed it, that amount was gone. So you think Rs. 5000 is the opportunity cost? yes. However it is a little more too. Suppose you are now 22 years of age and you understand compounding. ‘Rule of 72’ is the rule of doubling. Suppose you had invested this money and it earned 18% pa. So your money would have doubled in 4 years…so at 70 when you are wondering….you see this gift as Rs. 2 crores. Doubling every 4 years – so about 12 times by the time you are 70!!
Now come to task of paying interest. If you down pay very fast (or invest smartly)can you see the impact on your wealth? This is the concept of Foregone Future Value of Interest – and cannot be seen by most intellectuals including people working with big investment banks! Odd, is it not. I am wondering whether I should write a full book on inflation, interest rates, opportunity costs, and compounding. Maybe an E book for giving it to kids in class 7 or 8?
Now take this concept to a bigger loan – my favorite – the home mortgage. Given the size of the loan, it is fairly obvious that the opportunity missed is much higher!
Now take a worse case. You borrow because you do not have money, and it is not something you can do about. However say you on an average leave Rs. 10,00, 000 in your Savings bank account. How much have you missed out? Well Rs. 20000 is what you got. What you missed out is Rs. 80,000 – which you could have got by shifting this money to an interest bearing corporate fixed deposit.
Assuming you did this at age 34……go calculate the Opportunity Cost and burn…..
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