Friday, 26 October 2012

Interest Rates


Interest. It's the killer isn't it? 

Understanding how it works is key to managing your cash well and staying in good financial health. You would think, as the writer of this blog, that I think all debt is bad, and 90% of the time, you'd be correct too. However, borrowing money is sometimes necessary.

Buying a house for example. 

I could have put money away for each month for umpteen years and then bought my house outright without paying any interest, which on the face of it sounds like a financially savvy way of doing things, but I'm glad I didn't for 2 reasons:

First off, I would still have to live somewhere and I wouldn't want to live at my parents' still, so I'd be paying rent. Rent - that's money straight into someone else's pocket. Besides, I'm pretty sure my parents would want some rent off me too, whether they would want me living there though is a different question altogether! Paying a mortgage means at least some of the money you pay goes towards buying the property.

The housing market. Even if you could live somewhere rent free in the meantime, it is probable that taking a mortgage instead of saving up, you would still come out ahead. For example, my house is now worth roughly double what I paid for it 12 years ago. Taking into account I put down a 10% deposit and a mortgage for the rest over 25 years, if I had saved that money instead, it would have still taken me 25 years to raise enough money to buy it TODAY'S price, so effectively I'd be 13 years behind on that.

Then there's credit cards. Credit cards are really big money makers for banks. Here's something to think about:
A credit card has a balance of £3,000 on it. (Fairly average I'd say?)

The minimum monthly payment on it is 2.25% of the outstanding balance, and the monthly interest is 1.527%. Doesn't sound too bad, but think about it for a moment. 1.527% every month of the year, quickly compounds up to 19.9% APR*. Doesn't sound so good now does it? And that's not the worst, oh no, not by a looooong way!! 
To pay off that credit card at the minimum payment each month would take over 30 years and you would pay several times the original balance itself in interest.

Why? Because every month, what you're really paying off that card is this:

The minimum payment of 2.25% minus the interest rate of 1.572% gives = 0.723%

Your balance decreases less than 1% every month
If you want to know where I got these figures from, I'm quite good at maths and made up a spreadsheet to work it all out. In a future post, I'll be writing about credit cards, and I will release this spreadsheet so you can have a go yourself and put your own figures in. Should be good for seeing how fast you can tell your credit cards where to go...
( 18/12/2012 OK I've done it now - click here for the post containing the spreadsheet)

Compound Interest

In the previous paragraphs I also mentioned something about interest being compounded. This is basically interest on interest, and it's something very powerful. You can see how it works for credit cards, and how to avoid falling foul of it, but it's not all one way. You can make compound interest work for you too.

Yes, I'm talking about savings and investments.

Quick Example:
£100 stuck in a savings account at 4% (about the best you're going to get at the moment)

Year 1 - £104.00
Year 2 - £108.16
Year 3 - £112.49
Year 4 - £116.99
Year 5 - £121.67
If you took the interest out every year instead of letting it pile up you would earn £20. Compounding the interest gets you an extra £1.67.

OK, so you can see 2 things from this. Compounding your interest gets you extra, but 4% isn't a great rate.

This is why I look at investing my money, for higher rates of return. Here's another example at 18%:
Year 1 - £118.00
Year 2 - £139.24
Year 3 - £164.30
Year 4 - £193.88
Year 5 - £228.78
In this case you can see the higher rate really works well for you. Withdrawing the interest instead of letting it compound would earn you £90, but compounding now boosts this to over £128 instead.

In America, buying stocks and shares is a very common thing to do, as such, there was a case recently of a woman who invested $5,000 in shares in her 40's. She always re-invested her dividends and interest until the day she died. Over 42 years, without investing any additional funds, her initial lump sum had grown to a somewhat  amazing $22M.

It's at this point I should mention that both here in the UK and other countries, the interest generated by your savings is classified as income and therefore a percentage is taken as tax. Having seen the difference just a few percentage points can make either way to compounding, it's a very good idea to look at the tax free savings schemes most countries have available (ISA's in the UK) and utilise those to your full advantage. If you use one for your emergency slush fund, remember to get one with instant access.

*What is APR?

APR stands for Annual Percentage Rate. This is basically the interest rate worked out over a year. ALL financial products in the UK have to state an APR so you can compare like with like, (I think this mayapply in the US as well). Take any loan, credit card, mortgage, or other credit and you can instantly see which is going to be the cheapest for a given amount. Savings accounts also use APR, again for comparison, so you can see which is the best deal.

It's also useful for looking at the difference between savings and borrowings. For instance, if you had a mortgage for £100,000 at 2.5%  APR, £5,000 in a savings account at 5% APR  and a credit card with £3,000 at 19.9%, the best thing to do with your money is use the savings to pay off the credit card.

Going back to credit cards for a minute, some people use credit cards to do something really clever called:

Stoozing

This is where they apply for a new card that offers 0% interest for say 12 months. When the card arrives, they do a balance transfer to their bank account, and stick it in a savings account for 12 months. When the 12 months is up, they withdraw all the cash, and pay off the credit card. Borrowing the money has cost them nothing and they get to keep the interest earned.

So as you can see, knowing a little about how interest works can really pay dividends(!)

5 comments:

  1. I enjoying discussing the topic of interest rates. It is pretty much what drives debt and the economy. I bought my apartment a few years ago with a small downpayment for the same reason. Apartment value has gone up by more than 15% since then. Good thing I didn't wait. All my savings would have just gone to the current seller lol. ISA sounds a bit like the TFSA we have in my country.

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    1. Having googled TFSA and read a bit very quickly, yes ISA's are similar, although you also have a very, very good perk, whcih we don't. Your tax free allowance is carried forward each year I believe?

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    2. Yup, I believe you're right :)

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  2. An excellent summary of interest. Most people don't understand interest and that's a great way to explain it! I'm writing an article just now about how my wife calculated us repaying our mortgage. Hilarious but financially frightening at the same time.

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    1. I look forward to reading that John

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