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Two sides to compound interest

Nov 15 2014 10:49

Cape Town - With more than half of all economically active South Africans in debt and many of those battling with bad credit records, it may be more effective to try and build a ‘not spending’ rather than a ‘savings’ culture for the country, according to Scott Field, chief operating officer of independent life insurance group FedGroup.

“For people in debt, finding the extra money to put away into a savings account is difficult."

Not spending money that you don’t have to is much easier, both conceptually and practically. And, it’s compound interest that can make that possible, he explained.

Compound interest is interest earned not just on the capital amount saved or spent, but also on the interest that accrues to either the savings or the debt.

“You see the negative side of compound interest, for instance, if you buy a car using vehicle finance,” explained Field.

The car’s purchase price might be R250 000, but, over the five years of the finance contract, you will end up paying R334 000. That’s R84 000 you would not have needed to spend if you’d paid cash.

“But, the power of compound interest can be used in your favour too. If, at the end of your five year contract, you kept the car for an additional three years and paid your instalment into a savings account, you’d have enough at the end of the period to buy a new car for cash," said Field.

“You’d never need to buy another car on credit again.”

Field gave the example of someone investing R15 000 at the age of 25 in an account paying 5.5% compound interest annually.

When she is 50 - that is 25 years later - she would have R57 200.89 in the bank. By contrast, if she invested the same amount at the same interest only at the age of 35, she would have R33 487.15 by the time she turned 50 - 15 years later.
 
“Clearly, the longer you allow compound interest to work, the more money it will make for you. Also, the smaller the amount with which you start, the longer you should leave it to accumulate interest," he explained.

“But, the principle remains sound: instead of spending money on compound interest by incurring debt, use it to make the kind of money that will keep you debt free for the rest of your life.”

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interest rates  |  money  |  money management  |  insurance
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