In the previous post I answered the question What is financial literacy? In summary, it is understanding how money and personal finances work. There are 7 key principles to improving financial literacy that apply to everything. If you know these then you will have a good foundation to build on.
7 key principles to improving financial literacy
- Know how much money you earn
- Spend less than you earn
- Time value of money
- Effect of compounding
- The real cost of debt
- Pay yourself first
- Risk versus return
Look at the first 4 principles in detail and see if you can answer the relevant questions
Know how much money you earn
- What is your cost to company or gross salary, what is net salary?
- How much tax are you paying?
- Do you have pension fund, what are the contributions?
- What another benefits are you paying for?
- What are the other deductions?
Spend less than you earn
- What does this mean?
- Why must you spend less than you earn?
- How do you avoid debt?
- Why is budgeting important?
Time value of money
- What is time value of money?
- What is inflation and what does it do?
- What is the effect of interest?
- Why is time important?
- How do you calculate future value?
Effect of compounding
- What is compounding?
- How does it work?
- Why must you start young?
1. How much do you earn
We all earn a salary but do you really understand what your salary consists of? Some pay slips can get quite complicated. Most people just look at the amount that hits their bank account or lands in their pocket and think this is their salary. That amount is called your net salary after deductions.
If you don’t have any deductions then your net salary is the same as your gross salary. The type of salary can vary depending on your job, could be fixed salary, commission, bonus, overtime etc.
Gross salary is the total money that your company pays you, also called total cost to company. From that gross salary your company will make some deductions either because they are obliged by law or because you have instructed them to. These other deductions usually relate to benefits provided by your employer.
Understand your deductions
The biggest deduction is PAYE (pay as you earn tax), this goes to the tax man and is calculated according to the relevant tax tables. Your company will deduct the money which they then pay to SARS. Once a year you fill in a tax return which is when you can make sure that the correct amount has been deducted. If not you will either need to pay in or SARS will issue a refund.
The next biggest is your pension or provident fund if you have one. Normally here your company pays a portion and you pay a portion. The portion paid depends on the scheme that your company has, the more your company pays the better the scheme. Mine is 16% , I pay 5% and my company contributes the other 11%. This amount may also include disability and life insurance. It is important to understand how much it is costing you and what you are paying.
The next biggest deduction will be for medical aid if your company provides that. If you have this then your company will pay a portion and you pay a portion. Then there may be other smaller deductions like funeral benefit, UIF etc.
2. Spend less than you earn
This sounds so obvious but fact is that the majority of people in South Africa spend more than they earn. Just by understanding this simple concept you will be improving your financial literacy.
Once you receive your salary your money will land up going one of 3 ways.
- You can spend more than you earn which means you will borrow money to make it to the next pay day.
- You spend everything that you earn and have nothing left.
- You spend less than you earn and you have some money over.
No matter how much you earn you have to manage your spending so that you spend less than you earn and always have money left over. As your salary increases from promotions or annual increases you should avoid spending more just because you earn more. Rather land up with extra money left over at the end of the month. If you do this you will not only avoid having debt but you will also be able to save and invest.
Budget to save
To achieve this you need to make a budget. This is a plan of how much you will spend on what for the month. It is a critical skill for improving financial literacy. This will help you to know what you are spending your money on and make sure that you are not wasting your salary.
In your budget you will have fixed or recurring expenses and variable expenses. The fixed and recurring are essentially the bills, those that get paid automatically or you have a commitment for. The variable are those that you may or may not spend during the month.
The most important reason for having a budget is that you can have a plan before you spend your money. This will allow you to make decisions before you spend your salary. If you see from your budget that you are going to spend more than your salary then you can make adjustments to your plan. It is too late once you have spent the money, then you have the debt.
If you want to spend less than you earn then you need to have a plan to make this happen. Using a budget you can estimate how much money you will have left over. Then by adjusting your budget you can maximise this amount by reducing planned spending.
Just remember that a budget by itself will not do anything. You need to take action and have the discipline to follow through on what you planned. This requires making the right decisions everyday when you are faced with spending money.
A great tool to use to track your spending and manage your budget is the 22seven app. Using this app you can set your budget and spending limits, receive notifications and track your progress.
3. Time value of money
The most important concept you can learn is the time value of money. My journey to improving financial literacy started here. Money will lose value overtime if you do not invest it. However, money will gain value over time if you do invest it.
Money loses value overtime due to inflation. Inflation means that everything gets more and more expensive every year. So if you keep your money under your bed then you will find that you can buy less and less with the same money as time passes.
If inflation is 7% and you could buy 10 apples for R100 today then in 10 years time you will only be able to buy 5 apples for the same R100.
Similarly if you invested the R100 at 7% interest for 10 years then it would be worth about R200 so you will still be able to buy your 10 apples.
So the learning is that as time passes you need to invest the money that you have got and you need to earn more money every year to cover the increasing cost due to inflation.
How to calculate future value of money
Understanding the calculations is important in grasping and improving financial literacy. Lets calculate the future value of R10 000 invested at 9% interest rate over a period of 15 years.
The present value is R10 000
The interest rate is 9%
The number of periods is 15 years
The difficult way to do this is to use the formula below. Using the present value of R10 000, interest of 9%pa and a period of 15 years that investment will be worth R36 425.
The easier way is to use the FV function in excel which you will find under formulas or fx insert function. It also explains how to use it.
4. Effect of Compounding
Improving financial literacy means using all the knowledge that you have to grow your money. The reason money increases value so drastically over time is not just due to interest. It is due to the effects of compounding.
Compounding means that your value growth is re-invested and you get growth again on top of your previous growth. Think of it as a snowball rolling down a hill picking up a bit of snow on every rotation. Here is a great article explaining the effect of compounding.
Consider the following example below that shows the difference when 10% interest is applied to R10 000. Without compounding the 10% interest means that you will only add R1 000 every year so in total the interest earned over 10 years is R10 000. However when you apply compounding you earn interest on the previous years interest as well.
If you apply compounding annually (10%pa), after 10 years the interest earned is R15 937, that is R5 937 just from the effect of compounding. If you apply compounding monthly (10%/12=0.83%pm), after 10 years the interest earned is R17 070, that is R7 070 just from compounding.
The big secret of compounding
The big secret with compounding is that it increases exponentially which means that the growth is bigger year after year. Look at the graph below to see how the value of R10 000 increases to R 1.174M over a period of 50 years with annual compounding.
In year 1 the value increased by R1 000 but in year 50 the value increased by R106 719, in one year! Here again you see the multiplier effect of monthly compounding in action. Compounded monthly over 50 years R10 000 becomes R1.456M, that is R280K more interest than even the annual compounded total!
This is the reason that all the advice is to start investing early. The earlier you start the more time your money has to benefit from compounding. If you invest early enough you will be able to create a lot of wealth with less of a contribution.
Nominal vs effective rates
When interest rates are quoted you must understand if it is the nominal rate or the effective rate
Nominal rate is quoted as an annual rate excluding the effect of compounding. Nominal rate is the same regardless of the length of the loan or investment period
Effective rate is quoted as an annual rate including the effect of compounding. The longer the investment period the greater the effective interest rate.
Effective rate is always higher than the nominal rate.
In our above investment example you can see how this looks in numbers. The 10% nominal rate with out compounding yields an effective rate of yes you guessed it 10%. If it is compounded annually then the effective rate is 15.9%. If it is compounded monthly then the effective rate is 17.1%.
Banks can quote either and may sometimes quote the nominal rate for loans so the number is lower. But for savings accounts they can quote the effective rate so the number is higher. You can’t compare one with the other. The best way to compare rates is to compare the nominal interest rate, as that doesn’t take the length of time invested into account. Here is another great article helping you understand interest rates.
Improving financial literacy
Financial literacy is a matter of grasping key principles and understanding how they affect your money. These first 4 principles will go a long way to understanding the language of money.
Next post we will look at the last 3 principles.
You shouldn’t take any of this as advice, consult a professional financial advisor for that. This is merely what has worked for me and my experience. Comment below on what have been the most important principles for you in improving financial literacy.