Question

Your family business plans to buy a new build­ing for AED 2,600,000. NBAD offers you a 30-year loan with equal monthly payments and an interest rate of 7.5% per year. The bank requires that your firm pay 20% of the purchase price as a down payment. This means that you can bor­row only 80% of the building value. Today, you have only AED 100,000 in your savings account, and NBAD can give you 5% return per year on your savings.

(a) Why do you think NBAD normally requires any borrower to pay 20% of the purchase price as a down payment?

(b) Explain the importance of the effect of compounding if you plan to save some money for the future.

Answer 1

(a) Reasons for any borrowers to pay a % of downpayment

In this case, NBAD required for the borrower to pay 20% thus, giving financials assistance for the remaining 80% of amount needed:

• A down payment is done as a factor to check if the borrower is financially stable.
• If the borrower is able to pay from his or her side the small percentage from his side without further borrowing, it reflects that loan amount is a planned amount and thereby giving the borrower a sense that even the payments for loan installments shall also be planned  
• Usually amount of loan provided is recovered by banks in equal installment over a longer period of time like in this case for 30 years, thus for banks to invest the entire amount makes it highly risky
• Also, usually the % is decided by fact that in future how much the asset could depreciate in value if borrower is unable to pay off the installment. Thus, say in this case NBAD feels that 20% is that value then in case borrower doesnt pay the installments, they would sale the asset and recover the loan amount from such sale value.

(b) The importance of the effect of compounding if you plan to save some money for the future

• Compound interest is one of the most important concepts to understand when managing your finances. It is the simplest yet the most powerful concept and has a multiplier effect on your investments.
• It helps your investments to grow at an exponential rate than arithmetic linear rate. Earning a slightly higher rate of return can make a massive difference to the amount of money you end up with.
• Compounding is a long-term investing strategy it takes place when the returns or interest generated on the principal amount in the first period is added back to the principal amount in order to calculate the interest for the following periods. Thus, it creates a chain reaction by generating returns on the returns as long as your money remains invested in the financial instrument.
• Comparison with Simple Interest : The easiest and the simplest form of calculating interest on your investments is simple interest. Simple interest is the interest earned on the initial investment made. Say, you have invested ₹ 1,00,000 at 12% per annum for a period of fifteen years with returns calculated by using simple interest.The interest earned would be ₹ 1,80,000 i.e. ₹ 12,000 each year.Continuing with our earlier illustration, if ₹ 1,00,000 is invested at 12% p.a. compounded annually, at the end of three years, the interest earned would be ₹ 4,47,356.58 . Unlike simple interest, the base for interest calculation increases every year as the interest is re-invested. In the above illustration, the difference between the two is low since the amount invested is for a lesser duration and the frequency of compounding is only annual.
• The difference becomes more significant with longer periods and more frequent compounding as simple interest grows in a linear fashion while compound interest grows exponentially.
• Like in given case, if we assume, loan taken is for 100% amount for 30years with interest being 7.50%, though the monthly installment looks small at AED 17,737, but total amount payable over loan duration shall be AED 63,85,169 which is around 2.50 times the loan amount.