The Beast of the Night called Debt

EMERGENCY POST!

While cycling to work this week I saw a newspaper headline telling me that South Africa is "the world's most indebted nation". I was going to post something about where to bank or where to invest in South Africa this weekend, but debt is such a serious emergency that this post cannot wait any longer!

The Beast of the Night Called Debt
Photo credit Pablo Piedra (CC-BY 2.0)

To see why debt is such a terrible thing. Let's take a look another look at the formula that tells us how how our investments grow with compound interest:

which we can compare to the formula that tells us how our debt grows:

See any difference? You shouldn't, because they're the same. That's right, the same power of compound interest that can help you buy freedom when you invest, acts against you when you're in debt.

When you have an investment it grows exponentially and when you have a debt it also grows exponentially - according to the same laws of mathematics. It is said that "Those who understand compound interest, earn it. Those who don't, pay it." My true hope is that you will come to truly understand compound interest. If you can't wait for what I plan to write in a future post - begin your studies here and work your way up.

The current prime lending rate in South Africa is 9,25%. Credit card rates are anywhere between 14% and 23%. Borrowing money at any of these rates can only lead to real financial difficulties. If we take inflation into account, then the prime lending rate is effectively about 4,25% and credit cards are between 9% and 18%. If you have any debt at these rates, then paying off this debt gives you a guaranteed real return (above inflation) equal to that rate. So paying off debt fast and aggressively is the wisest thing you could do.

Good debt? Rare and risky if it exists.

People often talk about "good debt". I'm not going to completely refute this idea, but I do feel the need to highlight the only conditions under which debt can be "good":

1. The interest rate that gets paid on the debt is low. This automatically excludes all credit cards as well as borrowing money for a car. Oh, and buying anything on hire purchase is a seriously bad idea.
2. The borrowed money is being put to good use. This means that you're not borrowing money for general life expenses or leisure expenses. Putting the borrowed money to use means you're using it to earn more money (a concept referred to as leveraging). This can definitely be profitable, but you really need to know what you're doing. The borrowed money could be to start a business or to inject additional capital into an existing business.

Personally, I don't like debt at all. I believe that you should up for anything you want to buy with cash. Yes, even a house. But I do acknowledge that money might need to be borrowed in order to produce an income with which to do the saving (as in the business example above).

So credit cards... what role do they play in our quest for financial freedom? Firstly,

Credit cards are not for borrowing money. 

They are for managing your cash flow better. Most credit cards in South Africa give you about 55 days interest free (the actual number of days is not important, only that it is more than one month). This means that when you use your credit card to buy your groceries and pay for strictly necessary expenses the actual cash you have earmarked for these expenses sits in your bank account earning interest! As long as you pay your credit card in full, every month, then you will never pay interest. This is the only way to use a credit card! Never pay only the minimum amount due (it's a trap!). Never let a month go buy without paying the full amount owing. If you don't have the self discipline to do this then you should not have a credit card.

We aren't fortunate enough in South Africa to have the types of credit card rewards programmes that they have in the US. So we might not be able to actually earn money from credit cards, but we can shop around and choose a card that will cost us the least.

The best card that I could find is from Virgin Money - there are no monthly, yearly or admin fees. Internet banking with this card is free. They do have some other rewards, but none of them are really relevant to our family's needs.

I'll do another post on the rewards programmes that we do have in South Africa, but in the meantime I'll share my conclusion: they're not worth it. Now this conclusion depends on your individual spending patterns and circumstances so you will have to do your own calculations, but in most cases the rewards escalate with spending. If you're planning on living a frugal lifestyle to generate fuel for your financial independence engine then rewards programmes won't benefit you because the very thing they reward is consumption.

For more takes on just how serious debt is, let me point you towards Mr Money Mustache who tells us that "debt is an emergency" and jlcollinsnh who says that "debt is an unacceptable burden".

So to summarise:

1. Don't get into debt in the first place.
2. If you already have debt, pay it off as fast as possible.
3. Use credit cards wisely and not for their advertised purpose.

Now go forth and defeat the Beast of the Night called Debt!

Introducing The Two Pillars and Compound Interest

Dear Awesome Person

In the last post I stated somewhat cryptically that:

"Money can be used to buy freedom by not spending it."

Photo credit Julia Maudlin (CC-BY 2.0)

It's probably time to explain what I meant by this. I present to you what I consider the two pillars upon which a financially independent life is based:

1. Live a frugal lifestyle so that you free up money that can be put to good use.

2. Find sensible investments where your money 
will work hard for you, and one day, will be able to work harder than you possibly can.

The sensible investments can be thought of as a Powerful Financial Independence Engine 
and the money that you save by living a frugal lifestyle it can be thought of as Fuel for the Financial Independence Engine.

But first we need to understand the inner workings of the machine which allows the engine to function:

The Power of Compound Interest

Compound interest will be a ridiculously powerful ally on your quest when it acts in your favour. But compound interest can be a double-edged sword. If you get on the wrong side of compound interest then the quest becomes exponentially* more difficult. (The wrong side of compound interest is a Fiendish Beast of the Night called Debt; we'll talk about this in a future post.)

When money is placed in an investment (we'll look at what types of investments there are and where to get them in a future post) then it grows according to the compound interest formula**:

F is the value of the investment, P is the money you put into the investment, i is the rate of growth and n is the amount of time you invest for.

The value of your investment is larger for larger values of P, i and n. This makes sense:

• the more you invest (P) the more your investment should be worth
• the faster your investment grows (i) the more it will be worth after a certain amount of time
• the longer you invest for (n) the more time you give compound interest to compound the growth on your investment

For now, let's look at a pretty amazing example of how the growth rate (i) and time (n) can work together to produce a snowball that starts small but eventually produces an avalanche of treasure.

If you can find an investment that produces real returns (returns above inflation) of 7% then an investment doubles approximately every 10 years. Using the compound interest formula we have:

What does this mean? Let's perform a thought experiment. Imagine that you have R100. I maintain that this is actually a lot of money and should be respected, but depending on your frame of reference it's not that much and shouldn't be too hard to find (chances are you have a R100 note in your wallet right now; go and fetch it and you don't need to imagine having one). Now imagine that you invest this R100 in an investment that grows at 7% per year above inflation. In ten years time you will have the grand total of... R200. Wow, that's a bit anti-climactic isn't it? Where is this phenomenally powerful engine that I promised? Be patient, the juggernaut is just getting going. 

• After 20 years you will have R400.
• After 30 years you will have R800.
• After 40 years you will have R1 600.
• After 50 years you will have R3 200.
• After 60 years you will have R6 400.
• After 70 years you will have R12 800.

"Okay", you might say. "That sounds like a lot of money, but it took 70 years to do that!" I'll be amongst the first to admit that 70 years is a long time to wait. But just think about what just happened. We took R100 and turned it into R12 800! This is an amount of money that could easily be spent on going to the movies, having take-aways or going out for an evening and you might not even notice spending it. But if you invested it instead of spending it, in 70 years you could have R12 800 to leave to your grandchildren as an inheritance or to donate to charity.

Let's be a bit more ambitious. Let's say we've managed to save up a small nest-egg of R10 000 that you were planning on putting towards something completely unnecessary like a new HD  TV or a fancier car. What does that become in 70 years?

R1 280 000 or R1,2 million.

Okay, that's a little more like it. But still, why am I talking about investing over 70 years if I'm trying to show you how you can use compound interest to achieve financial independence in a much shorter time frame like 10 years? It's because the interest rate (i) and time (n) are not the only factors that affect the final value of your investment. The amount you actually put in (P) has a profound affect on what you eventually get out. I needed to talk about periods of 70 years to give compound interest enough time to work because in our thought experiment we were not being ambitious enough. We were putting R100 or R10 000 away once off and then thinking that this is enough. Compound interest is powerful, but it won't achieve financial independence on its own. It needs something to compound on!

The general financial advice given when saving for retirement is "save 10 to 15% of your income and you'll be fine". Only saving 10 to 15% is what means you'll be working until you're 65. You're not letting P (what you put in) do enough work in the compound interest formula, so n (time) has to make up for it.

If we have a certain target, which will allow us to be financially independent (and we can talk about how to decide on this target in a future post), this is your F. So how do we reach this target?

Start investing now.

This makes n large in the compound interest formula giving compound interest more time to do its thing. Since we want n to be as small as possible for our target F (hello EARLY retirement), we need to increase P and i as much as possible. But of course, we should also start the process as soon as possible so that we maximise n without selling ourselves to work forever.

Invest as much as you can. 

This increases P in the compound interest formula. Increasing the amount invested comes from living a frugal lifestyle so that expenses are reduced and that there is more money to invest. This forms Pillar 1, which we'll talk about in more detail next time. It sounds so simple but there is a lot to it!

Increase your rate of growth

Invest in something sensible that will give you as large a growth rate as possible over the long term. This increases i in the compound interest formula. Increasing the rate at which your investment grows by choosing the right investments and investment platforms makes up Pillar 2: this requires a lot of thought and research as there are loads of pitfalls along the way.

Making use of the mathematics behind the power of compound interest will have you saving hard initially in order to increase P. Then once you've reached financial independence you can simply let i and n take over. That's freedom. Your money works so you don't have to.

Mr Cent(ri)Frugal Force


* Literally. Compound interest (on investments or debts) is an exponential function. Mathematically powerful to say the least.

** For multiple investments of different sizes made after time intervals of different length and with varying rates, the formula is a lot more complicated, but the factors that affect the final value of an investment are the same: P, i and n - it's just that none of these are constant.