The Magic of Compound Interest

The most powerful tool in the financial world is that of compounding. It is a phenomenon which even amazed Albert Einstein who was said to call it the 8th Wonder of the World.

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So what is it all about?
Essentially compounding is reinvesting the returns you make on an investment back into the investment.

For example:
You invest R500 in a unit trust fund which makes 10% in a year amounting to R50. Buying more units in the investment for the R50 starts the next year with R550. The following year the same 10% return is now made on a larger amount and the result at the end of the year is now R55. By reinvesting the 3rd year starts with R605 which returns R60,50 at the end of the year.

Consistent positive returns
So the way to maximise your savings is to save for the longest time possible in investments that consistently give high positive returns and then reinvest these back into the investments, creating the magical compounding effect over the period.

Time is needed
The longer you save the greater the effect. The same R500 in our example got to R605 over 3 years. If you continued over 10 years you get to R100 728 and over 20 years R361 993.

Be mindful of inflation
You need to beat inflation. The value of money into the future depreciates against the rise of the cost of living. This is called inflation. To keep the value of your investment real you need to achieve returns above the inflation rate. So, investments that achieve more than 6% (which is the current rate) will compound over time to provide real value which improves your wealth.

Reasons why an endowment is not for you…..

Endowments are policy contracts which commit you to a minimum investment period of 5 years after which the proceeds are tax free. They basically provide a so called “wrapper” around various funds of choice which may be invested in various assets, such as, equities, property, bonds and cash. The returns from these assets (other than equities) are taxed inside the endowment at a flat rate of 30%.

images-35Dividends from equities – 20%
Rental income from property – 30%
Interest from bonds – 30%
Interest from cash – 30%

 

REASON 1 – Tax rate lower than 30%
The first reason why you should not have an endowment is that if your tax rate is less than 30% you will pay more than you should to SARS. You would be better off investing in the same funds directly without the endowment wrapper.

REASON 2 – No cash fund in place
The restrictive period of 5 years ties your money up and if you need to access cash before hand then you could be penalised. A sound financial plan starts with cash fund which you can access for unforeseen expenses. The ideal balance in this account should cover your monthly expenses for between 3 to 6 months. If you don’t have access to enough cash for emergencies then you should not have an endowment.


REASON 3 – Debt not under control

If you have high interest bearing debts such as credit cards, personal loans, overdrafts and mortgage bonds then these should be tackled before investing in an endowment. The returns after tax, costs and fees from the funds in the endowment are unlikely to achieve the same rate as your credit card, for example, 22%. Paying off your debt is a sure thing, without risk of losing capital, effectively providing a guaranteed return at the rate the interest is being charged. Therefore, the third reason you should not invest in an endowment is if your debt isn’t under control.