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Your first car determines your retirement

Jul 14 2015 10:46

Cape Town - If this is your first year of real freedom, meaning no more studying and a proper job that pays a decent salary, you are in the best possible position to start building wealth by using the most powerful building block available, namely compounding.

Niel Fourie, public policy actuary at the Actuarial Society of South Africa, says compound interest is often referred to as the eighth wonder of the world, because if used correctly compounding can turn small amounts into substantial savings. However, cautions Fourie, compound interest will also work against you if you are not able to manage debt.

Fourie explains that when you are investing, compounding refers to the growth achieved on your original investment plus the growth on the returns already earned. If you are earning interest, compound interest is best described as interest earned on interest.

 
According to Fourie, your best opportunity to make compounding work in your favour will present itself when you get to buy your first car.  

“As a young professional, the temptation to buy something fast and flashy will be huge,” says Fourie. “You are likely to throw caution to the wind and tell yourself that after years of studying and hitching rides, you have earned an expensive car.”

Family responsibilities may not yet be on the horizon for you, and yes, you have probably earned a reward for all your hard work. But, says Fourie, it is at this junction that you have the power to shape your financial future.

“It may be hard to believe, but your choice of first car is likely to determine whether you live a life of debt repayments or whether you become a cash buyer and asset owner one day.” This decision, he adds, will also determine whether you retire comfortably or whether you are forced to rely on Government grants as well as your family for your survival.

Fourie has crunched some numbers that should help convince any young person to buy a sensible first car and invest the portion of salary not used for car repayments.  

Assuming that a young professional buys his or her first car at age 25 and replaces the car every five years up to age 65, the average professional will have owned eight cars when the time comes to retire.

The young professional will have the option of either buying a medium sized car that is safe and practical at, say, a cost of around R200 000, or something more expensive of around R450 000.
 
Based on a repayment term of 60 months at an annual interest rate of 12%, the repayment on the R200 000 car will be around R4 500 a month. The R450 000 car will require monthly repayments of around R10 000 a month. The difference in repayments is R5 500 a month.

After considering the monthly repayments, you do the sensible thing and you opt for the car that would cost R4 500 a month. You then take the R5 500 that you are not spending on a car and you invest it in a unit trust fund likely to deliver a return of 10% after fees every year.

If you maintain this investment from age 25 until you retire, you are likely to have available a lump sum of at least R5.3m in today’s monetary terms. For the sake of simplicity, Fourie has assumed the value of the car to be zero after every five years.

If, however, you always opt for the more expensive car at an annual interest rate of 12%, you will have spent R9.1m in car repayments by the time you reach 65.

Fourie points out that should you opt to not buy another car once your first car has been paid in full, you would be even better off.

In order to estimate how long it would take to double your money through compounding, the Rule of 72 is a handy tool. Simply divide the compound return that you are expecting to earn on your investment into 72. The answer gives you the approximate number of years that it will take for your investment to double.

Using the earlier example, if you want to know how long it will take to double your investment amount of R4 500 earning a 10% return a year, divide 72 by 10. The answer is 7.2, which means it will take just over seven years to double this money through compounding.

He points out that the later you start tapping into the power of compounding the lower your chances of achieving true financial freedom.  

retirement  |  money
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