Compound interest is one of the most powerful financial concepts around. When it works in your favour, it can be a catalyst for significant wealth. When it works against you, it can trap you in a financial death spiral which becomes increasingly difficult to escape.
Over December, I spoke to a number of business owners and many of them indicated that they were seeing more and more requests from staff for loans. Their staff had found themselves on the wrong side of compound interest and were not keeping up with their minimum repayments and were now looking for either increases or personal loans to help tide them over in December.
Interestingly, those who were struggling the most were those who could roughly be classified as middle-management and whose homeloans, car repayments and credit cards were overwhelming them.
What became abundantly clear is that many had gorged themselves on credit, but were not prepared to do basic arithmetic around the cost of this credit.
The cost of a car
During December I learnt two things:
Firstly discovered that cars can now be financed over either 6 or 7 years (as opposed to the 5 years that many of us had become accustomed to).
Secondly, I found out that an entry-level Opel – off the showroom floor – costs R200 000… if you buy it cash.
Let’s do the math on this. R200 000 car, 10% deposit, financed over 72 months with a 13.5% interest rate.
Monthly repayments: R3753
Extrapolate this over the 72 months and suddenly you’re paying R270 000 for a R200 000 car which is depreciating in value. Paying a bigger deposit or shorter term, makes it easier to get in front of your debt burden.
Seeing as you have opted to pay R270 000 for the R200 000 car, if you had paid a deposit of R90 000 (10% plus the R70 000 you were going to pay anyway), your monthly repayment drops to R2326.
The cost of your house
Without even debating the topic of whether your house is an asset or not, many people fail to do the math around the cost of interest on your house.
Here is the math:
R1m house with a 10% deposit and R41 713 in bond and transfer costs financed over 20 years with a 10.5% interest rate.
Your monthly repayments work out at R8843 and over the 240 months of the bond, you will spend … R2 122 320 servicing that bond before insurance, maintenance, lights and water. In other words, you are going to pay for that house twice over the 20 years.
Stealing from the future
For the middle-class, credit has been relatively easy to access over the past 20 years but very few people grasp that the majority of credit is simply a case of stealing from the future.
The argument is often made that a house appreciates in value and this ultimately should outpace the cost of lending, but many people would be astounded to know that the average house price in South Africa hasn’t risen over the last 5 – 7 years…. And this is before rising rates and taxes on properties.
You only need to make minor tweaks to your personal finance habits to start getting compound interest working in your favour. A simple example is that if you had a R500 000 bond and you opted to pay in R100 per month extra, you would knock nearly 16 months off your bond and save R50 000 in interest. For a lot of people, not paying a bond every month would change their financial lives.
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