With more than half of all economically active South Africans in debt and many of those battling with bad credit records, it may be more effective to try and build a ‘not spending’ rather than a ‘savings’ culture for the country.
So says Scott Field, chief operating officer for life insurance group FedGroup. “For people in debt, finding the extra money to put away into a savings account is difficult.
“Not spending money that you don’t have to is much easier, both conceptually and practically. And, it’s compound interest that can make that possible.”
Compound interest is interest earned not just on the capital amount saved or spent, but also on the interest that accrues to either the savings or the debt.
“You see the negative side of compound interest, for instance, if you buy a car using vehicle finance,” Field says. “The car’s purchase price might be R250 000. But, over the five years of the finance contract, you will end up paying R334 000.
“That’s R84 000 you would not have needed to spend, if you’d paid cash.
“But, the power of compound interest can be used for you, too. If, at the end of your five-year contract, you kept the car for an additional three years and paid your instalment into a savings account, you’d have enough at the end of the period to buy a new car for cash.
“You’d never need to buy another car on credit again.”
Eighth wonder of the world
So extraordinary is the power of compound interest that there is an apocryphal story about Einstein calling it the eighth wonder of the world.
What is true, however, is that when former United States president Benjamin Franklin died in 1790, he left $4 400 each to the cities of Boston and Philadelphia. Two hundred years later, Boston’s money had swelled to $6.5m and Philadelphia’s to $2m.
The reason for Boston’s greater sum at the end of 200 years was that it had followed Franklin’s instructions to allow young apprentices to borrow from the fund, growing it not only through compound interest on the loans it made but also through the repayments of the apprentices, on which compound interest was charged.
Philadelphia had been more cautious and not lent any of its residents money from the Franklin fund.
“Regardless of individual cities’ approach, the power of compound interest grew their initiatial investment from thousands into millions of dollars,” Field says. “It demonstrates that ordinary people with very little to invest can, over time, make substantial amounts of money. The key is time.”
Field cites the example of someone investing R15 000 at the age of 25 in an account paying 5.5% compound interest annually. When she is 50, 25 years later, she will have R57 200.89 in the bank. By contrast, had she invested the same amount at the same interest only at the age of 35, she would have had R33 487.15 by the time she turned 50, 15 years later.
“Clearly, the longer you allow compound interest to work, the more money it will make for you. Also, the smaller the amount with which you start, the longer you should leave it to accumulate interest.
“But the principle remains sound: instead of spending money on compound interest by incurring debt, use it to make the kind of money that will keep you debt-free for the rest of your life.”