Interest rates have crept up in the last year and anyone paying off debt has seen a dent in their wallets.
However, if you are smart, you can turn increasing interest rates into a positive aspect of your financial plan. Making sure to keep debt under control and prioritising a solid savings plan can make you seriously wealthy.
You don't need to be as intelligent as Einstein to understand concept of compound interest.
Simply put, when you invest money, you earn interest on your capital. The next year, you earn interest on both your original capital and the interest from the first year. In the third year, you earn interest on your capital and the first two years' interest.
The concept of earning interest on your interest is the cornerstone of compounding. It has a marked snowball effect because as your capital grows, the interest portion gets bigger and bigger. Even a small amount can grow into a substantial sum given enough time.
Make your interest work for you
The key to making interest work for you is starting early. The earlier you start investing, the more time you have for compound interest to take effect.
Someone who invests R200 a month from the age of 20 to 29 and then lets the investment grow is likely to have more money at 60 than someone who invests R200 a month from age 30 to 59.
Over long periods of time, the difference between investing at, say, 10% and 11% is enormous, so always look around for the best rates. Don't be discouraged if you can't save a lot. Regular saving of small amounts can build up an astonishing sum of money.
If you save R100 a month for 40 years and your investments compound at 12% a year, you will have R980 000!A simple way to work out the benefits of compound interest is called the 'Rule of 72'.
You can find out how many years it will take for your investment to double by dividing 72 by the percentage rate of growth.
So it will take nine years for your investments to double if they grow at 8 percent a year (72/8 = 9). But it will only take six years if your investments grow at 12% and so on.
The Rule of 72 is only a guideline, but it can give you a good idea of what to expect. Let's look at how the smart use of interest and a good investment strategy can change your life.
The difference between Sam and Susie
Sam and Susie met on the first day of grade one. At break, Susie shared her Kit Kat, Sam shared her Gummie Bears and the friendship was sealed forever.
As they went through the trials and traumas of school together, very different personalities emerged. Sam was a saver and Susie was a spender.
At 16, they both decided to get part-time jobs. Every time Sam got paid, she put half her money into her parents' bank account and spent the rest. Susie, however, spent every cent.
By the time they started college, Sam had saved up R2 500 and Susie had perfected the art of extracting money from her parents.
They both continued to work while studying. By the time Sam graduated, she was driving a car that was paid for in cash.
Susie used the somewhat unreliable public transport system. They both landed good jobs and earned approximately the same amount of money. Their monthly income after tax was R3 000.
Sam continued with her savings plan, paying R700 of her income into a Unit Trust-linked retirement annuity. Susie, on the other hand, realised she needed a car and borrowed the deposit from good old dad.
She took out a four-year loan and her repayment was R1 685 per month. In addition, she opened up a number of accounts and treated herself to an entire new wardrobe.
As the months went by, her income was all but consumed by debt repayments. Four years down the road, Sam's invest-ments were now worth R45 659. Susie had just finished paying off her car. Realising that she had to become more responsible with her money, Susie decided to start a savings plan.
By this time she had a monthly after-tax income of approximately R6 000 so she could afford to save R1 000 every month. Sam could have started saving R1 400 into her retirement plan but decided instead to keep it at R700 per month and start an after-tax savings program of R550 per month.
Five years later, by the time they were 30, Susie's investment had grown to R88 574 (growing at 15% net per year) and Sam's to R158 215. The interesting thing to note is that Sam had only put in R15 600 more than Susie, but her investments were worth almost double.
The reason for this is that Sam's investments were growing and 'compounding' for four years longer. When Sam decided to buy a townhouse, she put down a R50 000 deposit (the proceeds from her R550pm investment plan at 18% net return per year) and took a loan for R110 000 over five years. Her payment was R2 470 per month.
Susie, however, could only borrow a R20 000 deposit from her folks and financed R140 000 over 20 years for a very similar townhouse.
This is what it cost them both. Sam told Susie that she should look at paying her bond over five years instead of 20 but, at R3 282 per month, Sue did not feel that she could cope.
Unfortunately, this was going to cost Susie R445 560 more from her after-tax income to purchase the same home. When we look back at Sam and Susie's financial behaviour, the turning point was really when Sam decided to save R700 toward her retirement and Sue chose to buy a new car instead.
The 'opportunity cost' of that one decision could easily be measured as R445 560 of extra bond payments, plus R69 641 less retirement savings, equalling R515 201.
We could project further and say that the head start Sam has in her retirement portfolio will translate to R2 893 000 extra at age 55 but we'd rather not make Sue cry. So who would you rather be?
Are you a saver or a spender
Even if you are one of the Susies of the world, with a live-for-today attitude, a simple decision to change your habits could make you rich.
Your first step is admitting to yourself that you are living beyond your means and squandering monthly savings opportunities that would have given you financial peace. Once you face the fact that you have a debt and spending problem, you are at the first stage of fixing it.
Surveys show that almost everyone wants to become wealthy, but almost no one thinks they can achieve it. Based on this very simple illustration I'm sure you'll agree that Sam is working toward an enviable position – one of financial security.
Therefore, having read this article, you now know that you could (with a little extra knowledge and coaching) get on the right track and build your financial future. Or, you could forget you've read this and keep blaming the system. Tough choice?