On throwing money away.

With all of the talk in popular media about investing in property, etc. I was suprised to see this "gem" pop up. While it's a nice though to try and explain compound interest to people that don't understand it, it helps to cover all of the facts, that this article was missing two critical points: Inflation and Tax. Plus frankly it had some terrible advice tossed in for good measure.

Compound interest is great, and compounding should the first thing you look for in any "savings" account offering. Let's start off by what "compounding" actually is. Compound interest is where interest earned in a savings account is deposited automatically and regularly into that account to generate future interest. The important factors to consider about interest generation is how often it is calcuated (daily, weekly, monthly) and how often it is compounded. Typically the best you can expect is interest calculated daily and compounded monthly.

Now unfortunately the article was completely out of touch with inflation. Their example quotes an interest rate of 7% which in this market is very exceptional while the cash rate is so low. Looking at my current lenders the best compounding interest rate I can get is 4.1% Other lenders will offer higher but it's important to factor in whether or not that rate is compounded. As interest rates increase, these interest rates increase as well.  Before getting excited about the 20 year figure you need to factor in that in 20 years, $1 won't be worth as much as it is today. Today you can buy 3L of milk for $3 at Coles. At an average inflation of 2.5% the cheapest you will find it will be around $5.05 in 20 years. That doesn't sound too bad, but when you start looking at $400,000 houses today, that's $671,833 20 years from now.

Depending on how much money you already earn, 4.1% may not be enough after tax to actually keep you ahead of inflation. Currently the inflation rate in Australia is 2.4%, if you're earning over $180k then 4.1% is only earning you 2.25% after tax. (45%) Sad days. :[ If you're under $180k it's 2.58% so it's keeping you ahead of inflation... barely. Looking at more realistic figures:
$10,000 earning 2.58% compounding monthly for 20 years: $16,702
$10,000 in 2033 dollars at 2.4%: $16,069
Congrats, you earned $633. Obviously, regular saving will dramatically increase the end figure but that is a byproduct of saving, not strictly compound interest.

Savings accounts are a useful tool, but really should only serve as a holding place for better yield investments or future necessary expenses. They are by no means any way to "get rich" and it is idiotic to see compound interest pitched as a wealth creation tool.

The terrible advice they mentioned was this:
" It means instead of diverting every spare dollar to debt, bills or lifestyle expenses like most people tend to do, you should squirrel away a few extra dollars today so they grow into a nice, big pile of money years from now."

Now it should be pretty obviously that you don't default on a bill payment to put extra money in savings. However, it is also terrible advice to think that money diverted into a savings account is going to be better for you than paying down debt. Every form of debt you will be facing will itself be a compounding form. Credit cards, home loans, etc. This means that *every* day you have an outstanding balance beyond any interest-free period they are calculating additional interest for you to pay that far, far out-paces any interest you could possibly earn from a savings account. Credit cards are typically charging 11-16%, home loans right now will be around 5%

So if you diverted $50 a week into a savings account while you were still paying down a mortgage then you might have $60k in your savings account after 20 years, but you would have paid $80k or more against your loan. If you want to save money and you have a mortgage, utilize an offset account. This gives you 100% savings against your loan interest tax free.  What I mean by that is let's say you had a loan account for 5% and someone actually offered you a savings account for 5.5%. Seems like it would be better to use the savings account? Wrong. Assuming you were earning around $80,000 a year that 5.5% is only worth 3.47% after tax. The offset account is equivalent to 5% after tax. (You are taxed on interest earned, not interest saved.)

If you have outstanding credit card statements charging you interest then your priority has to be zeroing off these balances as quickly as possible. Credit card interest rates are head & shoulders higher than mortgage rates and savings accounts. If you can, get the balance transferred to your mortgage and cut up the credit card.

In summary, creating wealth while managing debt is only possible provided that the investment avenue out-paces the interest charges of your debt *after tax*.