Interest — it is the vital return on your investment

Press, 12 May 1981, Page 12

Interest — it is the vital return on your investment

Dollar wise

Diana Shand

Let us leave the philosoohv of investment this week, and bemuse ourselves in other ways.

Understanding interest is a suitable and necessary exercise.

. Getting some return for investing our money is the major reason why we don't leave it brewing’ in an old sock. Wise investment decisions require knowing how monetary returns (interest) can be calculated; understanding the effects of inflation, and considering how your gains will be treated by the tax department. Interest calculations. Here the basic rule is that the amount of interest is equated with the amount of risk involved with the investment. Anybody taking a ticket in a lottery must realise this fact of life.

The prize is enormous, but so is the risk of losing your money altogether. Highly speculative investments like lotteries, bets on horses, shares in new mining companies (all with catchy names) are all gambles. When you settle for “average” return, you are accepting a lower interest rate on your money for the greater certainty of getting it. “Gilt-edged” or “blue-chip” are names given to investments thought to be safe and with predictable returns. Simple interest is the calculation most of us can handle. We multiply the amount of money outlayed (the principal - P) by the interest rate (i) .by the number of timeperiods (T) involved. Hence, lend out $lOO at 10% for one year and at the end of twelve months you get. back $lOO principal and $lO simple interest. (P x i x T S.I. $lOO x .10 x 1 $10). However, if part of the principal is paid back halfway through the year, you would be charging more than 10% if you still expected $lO interest. After all, you are really lending $lOO at 10% for six months, and then $5O at 20% for six months. So the true rate of interest is going to change if you expect repayment by instal-

ments yet the same return. To maintain the same simple interest rate, you must recalculate interest on the declining balance owed to you, every time you are repaid some of the principal. When you invest your money, if you don’t remove the interest that accumulates. it means that you are lending this out too. So at the end of several years you might claim interest not only for the original principal, but for the interest payments that have been sitting in with it.

This snowballing effect is that of compounding interest.

Now let us take this further. Surely whoever has your investment can use it immediately — so he or she should pay (interest) for that use immediately. So that means compounding starts at once and you can get rich quicker . . .? Unfortunately, this is easier said than done. Continuous compounding is certainly more feasible in this computer age, but you are unlikely-to get your interest calculated like that unless you are investing huge amounts of money. - -. -■ Still, the higher the inter,est rate, and the more frequently the borrower stops to calculate what he owes you — the more you benefit. So this is worth understanding.

Obviously, the nominal interest rate advertised by all these institutions wanting you to invest with them is only, accurate if calculated annually.

To find the true interest rate you must check on how often the interest is calculated and added to your principal (i.e. frequency of compounding and crediting). Note that this assumes that you are leaving the principal and any interest untouched during the period of investment. 1 ; One other little trick is to use “the Rule of 72” to calculate how many years it would take to double your money if it was left to compound annually. Simply divide 72 by the interest rate, e.g.:

@ 72 = number of years 1% to double your money • 72 - i-,3 years 15.5 Similarly, to find what interest rate you would need to double your money in a given number of years: • 72 ■■ -interest rate '. : Xyrs '-: V '; • 72 =24% 3yrs

Interest and inflation

Unfortunately, all ‘ these : pleasant calculations must ’ bear up to reality. We must calculate the real rate of; interest. Monetary returns \ and rates thereof only count “ dollars. ’

In these days of inflation we have to remember the ” purchasing power of our .5 money is changing — and ; always adversely. The real rate of interest is the differ-'I ence between money interest ’ rates and inflation rates. ' ,

If my $lOOO investment ‘ was to return to me as $1155 < (principal plus 15.5% 5.1.) at £ the end of one year,- and * inflation had been calculated as 15.5% — then I could buy | no more with the money I - had denied myself for a. year,, j than when I first invested it. In this case the real rate of. ? interest is zero. If inflation was 17.5%, the ’ real rate on 15.5% interest is .. minus 2%. £ Mind you, that is still.. better than if I had left my < money for a year in that olds ' sock. Left there, my $lOOO .. would now buy what would have cost me $865 at the ;, beginning of the year, i.e. a • real loss of minus 17.5%. * This is why people are; gnashing their teeth and desperately looking for a form \ of investing their money that will hold value, and even > earn a little more. Tax And on top of. all this — 1 the taxman cometh. Disre- ' garding the fact that you are i probably really losing : against'inflation rather than ' gaining in your investment ; gamble, your returns arestill income/ and are there- * fore /generally: taxable. § \

In view of this,, it really is t just as well that ..monetary S assets and monetary, income are not the only opportunities we have .. : isn’t at? i

TABLE 1 — COMPOUND INTEREST Beginning Interest Compound Year Amount (P) Rate(i) Interest to add to P next year

TABLE 2 Growth of SIOOO at 5-per-cent TOTAL INTEREST EARNED IN ONE YEAR IF INTEREST IS COMPOUNDED

$ $ 1 100 .10 10 2 110 .10 11 3 121 . .10 12.10 4 133.10 .10 13.31 5 146.41

Years Daily Quarterly Semi-ann. Annually S S $ $ . 1 51.30 50.90 50.60 50:00 2 . 05.20 104.50 103.80 102.50 5 ’84.20 282.00 280.10 276.30 10 649.10 643.60 638.60 ' 628.90 20 1719.40 1701.50 1685.10 1653.30