Compound interest is great in many instances especially when you are accumulating money. To put it simply, compound interest means interest being paid on interest. However, many people also fail to realize that compound interest is a double-edged sword.
Here are three instances to where compound interest can work against you.
#1 Credit cards
What happens when you always make the minimum payment on your credit card bills? Yes, you guessed it right. Not only is the interest rate extremely high, any outstanding balance which you bring over every month is subjected to the high interest rate.
Assuming that one do not charge any more payment to that credit card and continues making minimum payment the remaining balance will be subjected to interest on interest.
Hence you should always pay off your credit card bill in full each month to prevent your debt from snowballing.
#2 CPF Accrued Interest
In Singapore, many people will use their CPF Ordinary Account to pay for their home. Typically, CPF pays you a minimum of 2.5% per annum. Since your CPF will stop earning this 2.5% interest when you use it to purchase a property, you are expected to repay the interest along with the principal when you sell your home, before being allowed to withdraw any sales proceeds
Here’s an illustration:
If a couple purchases a house for $400,000. Using the interest of 2.5%, they would have to lost out on $112,000 of interest worth of CPF interest.
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This is a point that everyone should take note of when they are considering selling their home. After selling your house, the proceeds will have to go back to your CPF first. In our case above, this will be $512,034. While you might have lesser liquid cash due to this, it would be beneficial in the long run by ensuring that your retirement funds are taken care of.
#3 Daily Leverage Certificate (DLC)
Daily Leverage Certificates are a high-risk investment product recently launched on SGX. Basically, it offers investors a fixed leverage of three to five times the performance of the index daily. It designed to be a short-term investment and your base will reset at the end of each day resulting in a new base for each trading day. Hence, if you decide to hold a DLC beyond one day, you would see a daily compounding effect.
As with all other situations where compounding effect occurs, your gains or losses will become magnified. Compound interest is one of the biggest financial advantages that one can enjoy. Yet, it’s important to ensure that it doesn’t end up being mismanaged and affecting your finance.
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