In our last post we noted that financial literacy has a far-reaching impact on your quality of life. But the talking points of financial literacy tend to be opaque and full of jargon. To prove that it’s not as complicated as it looks, I picked up four basic rules of financial literacy and tried to explain them as plainly as I could.
This post will add three more basic rules to your toolbox:
- Interest payment
- Savings account
- Capital expenditure
1. Interest payment
Interest is the borrowers’ price for renting their money to you. The basic calculation goes like this:
Now, there are few details to work out here:
- Basic interest rate: the percentage the bank will charge you. For calculation purposes, the interest rate will go in the above formula with a decimal digit. (i.e. 0.05 means 5%) (Ps. There is also something called comparison rate. It is a basic interest rate plus any additional extras banks routinely adds on you to pay such as administration fee)
- Number of payments: number of payments you make per year (usually 12)
- Instalment: the amount you pay every month (excluding interest)
- Loan Principal: the amount you have borrowed from your bank
Let’s say you decided to borrow €10, 000 with an interest rate of 8.7 % over three years. Then, your first-month interest payment will be €72.5 calculated as follows:
Now that you start paying back your loan (via the instalments), the interest rate will slowly decrease every month. To calculate your new loan principal use this formula:
Your instalments are €277 per month (€10 000/36 months) which means that your new loan principal will be €9 723.
Don’t underestimate the effect of paying more when you can. If you increase your payment by just 10%, it will have a high impact on the amount of interest you’ll end up paying.
Avoid having a debt that is more than three times as big as your household income. If you decide to increase your monthly loan payment, make sure to pay more for short term loans than long term loans such as mortgages since they have a higher interest rate.
2. Saving accounts
A savings account is basically you lending money to the bank instead of the other way around. Which means that in this case, the bank has to pay interest to you. The interest is lower than if you borrow money but your fund is readily available if you need it (this is what’s referred to as a liquid investment).
Besides earning you some extra, saving accounts provide psychological comfort as they can give you the means to prepare for an emergency expense. It can also help to curb impulsive spending, since saving deposit feels and sounds more unreachable than the checking account.
- Open a savings account at a bank that provides a compound interest on your savings account. Compound interests let you gain interest on the interest you earned during the previous year. Savings accounts are compounded daily, monthly, or yearly.
3. Capital expenditure
Capital expenditure, or Capex, is an investment in yourself that will lead to a better income. It means that you spend a bit of time and money now that will improve the chances of getting more money later. A good example is to educate yourself further in order to change or improve your career, or exchanging your old fridge for a new, more energy-efficient one.
Do yourself a favour and make a ‘Capex’ inventory of your assets. The best place to start is yourself. With proper planning and little extra effort, you might find ways to acquire or upgrade the skills that enable you to earn extra some for that saving account of yours.