#JUSTSTART The power of compounding and why you should save

2015-07-07 15:01
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Satrix investments is committed to helping people save and more importantly understanding why you should start as soon as you can and stay invested for as long as you can.

Tim Modise is speaking to Satrix’s Candice Paine about compounding interest and why we should save. Of course, there’s a major difference between the different types of interest with the focus being on compounded interest this time.

Absolutely. Tim. Maybe what we need to do is explain what compounded interest is versus simple interest. Compounding interest is your interest on interest, where simple interest is a one-off payment on your capital. For example, if you invest R1000 and you’re going to get two percent interest; at the end of the year, you get R20. That’s simple interest. Compounding is when you start growing interest. The beautify of compounding is the more money you put into your investment and the longer you keep it, the more compounding you get.

The idea here, being to keep money longer in whatever vehicle you’ve invested your money in. How does it relate to interest rates, for instance? Of course, inflation has to be taken into account here.

When you look at investing, the first hurdle that you’re trying outperform is inflation. Investing is not a ‘get rich quick’ scheme. It really is about preserving and growing wealth at a reasonable rate. The first thing you want to do is outperform inflation and in the South African context, inflation is in the order of about five to six percent. Only thereafter, are you growing your wealth because inflation obviously erodes the purchasing power of your capital over time. You need to look at the kind of returns you’re getting. If you’re keeping money in your bank account, you’re lucky if you’re getting between half-a-percent and one percent, so there you are guarantee to be losing capital because it’s not growing above inflation. Our repo rate is five-point-seven-five percent and that is the rate at which, the Reserve Bank lends to other banks. If you have a mortgage loan, you’re paying nine-point-two-five percent, so it starts giving you an idea of what you need to achieve to get growth on your capital. Some of the astounding interest rates are things like credit card debt. You can pay up to 21 percent p.a. on the outstanding balance on your credit card, so you really need to be getting rid of debt and trying to increase your savings so that you can access the power of compounding.

Staying with credit cards here for a moment, the advice being to avoid using the credit card as much as possible, I suppose.

It’s not about avoiding the use of the credit card, but use it wisely. At the end of the month, pay off the total outstanding balance. Use the credit. Credit is there to be used. Don’t live on credit. Don’t spend your means.

If it goes up to 21 percent, it will be over a year, but then you divide that by 12 so that you pay less interest on it if you can it up within a month or something like that.

Absolutely, but it is compounded monthly if you can’t pay it within the month. It’s a very expensive way to spend and you should avoid credit card debt at all costs.

How can one save with debt? I’m just imaging. Just explain that concept.

Okay. There’s good and there’s bad debt. Good debt can reasonably be thought of as, for example, your mortgage. You’re investing in an asset, which is appreciating over time. Most people cannot buy a house with cash. They need to take on debt and there you’re paying your prime rate of nine-point-two-five percent. Bad debt is your credit card debt where you’re paying 21 percent, possibly on things you don’t actually need. If you have a mortgage and you are paying it off but you also want to be saving, you need to see where the return is highest and it’s always a relative game. If you believe you can get more than nine-point-two-five percent from the market, or a fund that you’re investing in, then you need to be saving over time, but don’t stop paying off your debt.

Of course, if you pay a bit more on the good debt you’ve spoken about then you’re likely to liquidate or pay it off within a shorter period.

Yes, and you pay a much less interest on that debt. Interest is the cost that the bank is charging you to use their money and you really, want to get that down as fast as possible. Yes, pay off more of your debt if you can.

You can even turn it into a savings account of sorts. If you pay more, you have a bit of capital left over, which you can access at a time you need more money, I suppose.

Yes, those are the access bonds, which banks are not that keen to hand out any long, but that’s the theory. If you pay off your mortgage quicker than stipulated, you can access that money.

Well, as we concluded, just illustrate this for me. Let’s say my time horizon is five years or ten years. Give me an example of what would happen if I took compounded interests into account as well as all the factors we’ve spoken about – just a case study.

Let me give you an example of a longer period. Say you took R1000 and you were getting two percent per year, and you kept on savings for 40 years (because that’s what young people have to save before retirement); with simple interests and no compounding, at the end of that period you have R1,800. With compounded interest, you have R2,208. That’s nearly R400 more with compounding. If you use much larger numbers, which are more reasonable from a lifestyle point of view, you really see that compounding is a free lunch.

Thanks very much for this talk. I appreciate it, Candice.

Thanks, Tim.

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