Interest Rates 101 – Understand It. Apply It. And Make Money

As mentioned in my previous article, we are heading into a tough year. The interest rate recently increased by 0.5% and more increases are expected during the course of the year. With the interest rate now having a bigger impact on our finances and hence our standard of living and quality of life, I think it’s important that we understand interest rates.

‘Money-management-by-the-numbers’, as I like to call it, is essentially managing debt, savings and investments according to the interest rate. It isn’t a difficult concept to grasp and I encourage you to take your time when reading this article, to be certain that you are able to apply the knowledge to your own financial planning as the information below will show you how you can make money with nothing but good money management. Since we are dealing with interest rates, the principle of compound interest applies so the benefits of this approach are tremendous over the long-term.

So, how can we ensure optimal money-management-by-the-numbers? Let’s take a quick test to find out:
• Contributing additional funds to a home loan instead of contributing those funds to a vehicle loan?
• Saving in a money market or a 32-day account instead of investing?
• Investing money while having an outstanding personal or high-interest loan?

If the answer to any of the above questions is “yes”, there may be room for better money-management-by-the-numbers.

How can we better manage our money?
1) When it comes to debt, do NOT pay too much attention to the monthly instalment. The priority should be getting the lowest interest rate possible.
2) Do NOT worry about the total cost of debt, i.e. the loan amount plus the interest. Far too often, people get upset when, for example, they see that a one million rand house will cost them three million rand over 20 years. Do not concern yourself with these figures.
3) The most important thing to focus on when it comes to debt/investments/savings, is the interest rate. It’s as simple as that. Always focus on the interest rate. If the interest rate on the debt is higher than the interest that can be earned from an investment, then pay off the debt. If the interest that can be earned from an investment is higher than the interest rate on the debt, then focus on investing more money.

Below are some common scenarios (interest rates quoted per annum):
• If the interest rate on a home loan is 10% and the interest rate on a vehicle loan is at 12%, pay off the vehicle loan first. Do NOT get tempted to increase the monthly instalment on the home loan because “the term of the loan drops from 20 years to 16 years”. Pay the vehicle loan off first then contribute the extra amount towards the home loan. Why? Because the interest rate on the vehicle loan is higher.

• Contributions to a retirement annuity offer the benefit of a tax deduction or a tax saving. This tax saving can effectively earn you more than 25% on your money. So do NOT contribute additional funds to a home loan or a vehicle loan that is at 10% or 12%; contribute the funds to a retirement annuity. On the other hand however, if the decision is between contributing to a retirement annuity vs paying off a personal loan or a retail account that is higher than 25% interest then do not contribute to a retirement annuity but rather pay off the loan/account.

• Lastly, a personal example – As a staff benefit, I can get a personal loan at an interest rate of 8%. So I applied for the maximum amount that I qualified for and invested the money. I am earning approximately 12% from the investment and I am paying an interest of 8% to the bank. If we use R100,000 as an example, then the loan is costing me R8,000 interest per year and I am making R12,000 by investing the money. That’s R4,000 profit without me spending a cent. That’s the benefit of effective money-management-by-the-numbers.

In ending off, let me add, and I can’t emphasize this enough - There are other factors which must be taken into account so please do NOT follow the above examples blindly. The examples are merely an illustration to convey how one must think when it comes to managing one's investments/savings and debt. As always, all financial decisions need to be taken from a holistic point of view.

Questions? Let's chat.