Compound Interest Explained: Loans

Compound Interest Explained: Loans
Sharm El Sheikh Egypt by Julian Cohen. Why?

In Hamlet, Old Polonius counsels "neither a borrower nor a lender be". He clearly wasn't aware of the power of compound interest!

(First published 12 December 2012)

One of the big things you can do with your SIPP is act like a bank and lend money from it.  After all, in its simplest form, a SIPP is a bank account surrounded by a tax wrapper. Subject to the agreement of your SIPP operator, you can lend your money in a number of ways.

This includes packaged lending like the Loan Opportunities you’ll find in our Invest area.  And you can lend to individuals or businesses as you’ll see in our Lend area.

When it comes to investing, the longer you leave your money invested, compound interest has the greatest impact. When it comes the loans, the reverse can be true.  Take Wonga, for example.  It offers very short-term pay-day loans. 

The daily rate is, without question, alarmingly high because of the convenience of immediate cash.  But when compound interest is applied in the form of the ‘Representative Annual Percentage Rate’, it comes out at a staggering interest rate in excess of 1,500 per cent!

I suspect if anyone actually borrows for a year, they’re going to be in very big trouble!

Consider This Realistic Lending Situation

You lend £50,000 from your SIPP for 5 years.  The interest rate is 10 per cent per year, payable monthly.  That’s interest of £416.67 per month.  You have two choices.

Scenario 1

The interest payments are transferred to your SIPP every month

Scenario 2

The interest accumulates and is repaid at the end of the term

So what’s the difference?

Once the interest is paid into your SIPP, it’ll go on deposit until you tell your SIPP operator where to invest the cash.  Most SIPP cash accounts pay very, very little interest.  Currently, 0.1 per cent is not uncommon, though if you’re really lucky, you could get a fraction more.

In this example, there’s not much you can do with £416.67 each month.  So most SIPP holders tend to let it build up and consider their options once a year.  A surprising number of people, however, don’t touch it for the term of the loan.  And that’s a really costly mistake as you can see below.

Scenario 1 - Receive Regular Interest Payments

At the end of the loan term, you receive back your £50,000.  You’ve already collected 5 years of monthly interest payments, amounting to £25,000.  And you’ve earned compound interest on those interest payments from your SIPP deposit account at 0.1 per cent.  A whopping £61.76!

In total, your £50,000 has grown to £75,061.76

Scenario 2 - Leave The Interest To Accumulate

Your interest accumulates with the full power of compound interest at 10 per cent.  At the end of 5 years, the total interest due is £32,265.44 and it's repaid with your original £50,000.

In total, your £50,000 has grown to £82,265.44

Compound Interest Is Worth An Extra £7,203.68

To put it another way, it's an additional return on investment of 14.4 per cent. 

If you have the option to choose the frequency of payment for your interest, always choose the smallest interval.  It'll enable you to earn 'interest on interest' to boost your return further.  Accumulating interest monthly will always earn you more than accumulating it once a year.

However you put it, compound interest earns you money for nothing.

Which Scenario Is Best For You?

Well, like anything to do with money, it all depends on your personal circumstances. 

Scenario 1 is likely to be your preferred choice in these situations:

  • You’re retired and you’re in Income Drawdown, so you need regular cash coming into your SIPP to cover your retirement income payments.
  • Your SIPP has borrowed money, perhaps to acquire a commercial property, and you need cash to meet the loan repayments.

I have heard it mooted that it’s good to have regular cash coming into your SIPP in case your borrower gets into difficulty and defaults on the loan.  At least you’ll have something to show for the money you’ve lent. 

Whilst that's clearly correct, quite frankly, if your initial due diligence revealed there’s a good chance that could happen, arguably you shouldn't lend the money in the first place! 

In any event, whenever you lend money from your SIPP, you should always take first charge security on relevant property or other assets to protect your loan. It goes without saying that unsecured lending is very risky.

In almost all other cases, Scenario 2 is likely to be the better option.  It's also a lot less hassle. 

If you're anything like me, you really don't want to be worrying every month about reallocating the cash in your SIPP, to prevent you from losing money. There's so many more interesting things to do with your time!

There's Another Advantage To Accumulating Compound Interest

Whilst it clearly costs your borrower more money, there’s a very good reason why both you and they might prefer it.

To take out a loan without having to make regular monthly payments for five years provides your borrower with a considerable cashflow advantage.  It gives their business the very best chance of success. That’s great for them. And it’s exactly what you need too.  For a more successful business has a reduced risk of a loan default. Providing, of course, there's a defined exit strategy at the end of the term when all of your interest and your capital are due to be repaid.

Three Ways To Maximise Compound Interest

Accumulate interest

Choose the longest term for the loan

Select the most frequent interest payment option

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