Compounding, the Good, the Bad and the Beautiful

I've been thinking a bit about Compounding and the important role it plays in my financial life.
I'm affected by compounding in a negative way by borrowings that I have, compound interest on loans, mortgages etc.
Also affected by the tax, prsi, usc that the State takes out if my wages.
Affected in a positive way by savings and pension.
It's such an important financial phenomenon and I haven't really thought about it too much but i'm trying to.
And seeing what ways I can reduce compounding working against me and increase it working for me.

Where 'negative compounding' significantly works against you is the '8 year deemed disposal' rule, as provided for by the Finance Act 2006. Effectively, it is an enforced sale of your fund or ETF, with Revenue taking 41% of your profit and then the remainder being reinvested in the same fund. It hits you in that if the deemed disposal rule did not exist, the money taken in tax would continue to earn returns in the fund until you decide to cash it in. So if you invest in your 20s, you can be hit by maybe 5 or more 'deemed disposals' before you cash in a fund in your 60s or later. You are missing out in paying tax 'up front' but more importantly, on the returns the money taken in tax would have earned if it remained invested. This is negative compounding.

A handy rule for compounding is the time it takes to double your money via compounding interest = 72/(interest rate). Known as the "rule of 72".

Currently compounding interest is not working in a useful way for savers. You might get a 0.15% return, then 37% DIRT, so around 0.1%.

72/0.1 = 720 years to double your money.

I would add the re-investment of share dividends to this. Instead of receiving dividends in cash, the money is used to by more shares.

PMU said:

Where 'negative compounding' significantly works against you is the '8 year deemed disposal' rule, as provided for by the Finance Act 2006. Effectively, it is an enforced sale of your fund or ETF, with Revenue taking 41% of your profit and then the remainder being reinvested in the same fund. It hits you in that if the deemed disposal rule did not exist, the money taken in tax would continue to earn returns in the fund until you decide to cash it in. So if you invest in your 20s, you can be hit by maybe 5 or more 'deemed disposals' before you cash in a fund in your 60s or later. You are missing out in paying tax 'up front' but more importantly, on the returns the money taken in tax would have earned if it remained invested. This is negative compounding.

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That was the point of it being introduced in the first place. People could quite easily invest for 40 years and not pay one penny of tax on those gains or dividends during that period. Previously to the gross roll up structure all taxes were paid within the fund and you always saw the net value of the investment.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

Is the deemed disposal rule only for monies not in a pension wrapper?

Ndiddy said:

Is the deemed disposal rule only for monies not in a pension wrapper?

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I can only assume so. Can anyone confirm this?

RichInSpirit said:

I'm affected by compounding in a negative way by borrowings that I have, compound interest on loans, mortgages etc.

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Loans and mortgages are not usually subject to compounding.

If you invest €100 @ 5% pa for a year (or any period with the interest rate over the same period) at the end of the first year you have €105. In the second year you earn interest on €105. That’s compounding.

If you have a mortgage you are usually charged and pay interest monthly so no compounding.

It is perhaps seen most clearly with an IO mortgage. If you borrow €100,000 you are charged say €500 per month interest. If you pay that monthly (or whatever the charging period is) then you never have to pay interest on the interest. No compounding.

Those equity release products for the elderly are probably a good example of bad compounding.

cremeegg said:

Loans and mortgages are not usually subject to compounding.

If you invest €100 @ 5% pa for a year (or any period with the interest rate over the same period) at the end of the first year you have €105. In the second year you earn interest on €105. That’s compounding.

If you have a mortgage you are usually charged and pay interest monthly so no compounding.

It is perhaps seen most clearly with an IO mortgage. If you borrow €100,000 you are charged say €500 per month interest. If you pay that monthly (or whatever the charging period is) then you never have to pay interest on the interest. No compounding.

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Loans are most definitely compounding but in a slightly different way to savings or investments.

Had to do a bit of a search on the internet for this but here is the formula for working out the monthly repayments on a mortgage or any other reducing balance loan.
Monthly Payment = (monthly interest rate*principal*(1+monthly interest rate)^number of months) / ((1+monthly interest rate)^number of months-1)

The PMT function in Excel does the same =-PMT(monthly interest rate, number of months, principal, 0,0)