Let me start this article by defining the terms Principal and Interest. Principal is the amount borrowed or amount still owed on a loan, separate from interest. It is also the original amount invested. Interest is the charge for the privilege of borrowing. The two terms are most commonly known to be used in debt but that is not our objective today. We will be introducing the debt aspect in the next article.
Say John is working and earns a net amount of Kes 50,000 per month. His total lifestyle costs Kes 30,000 per month (food, living expenses, rent, entertainment etc). He then diligently saves the extra Kes 20,000 every month for the next 15 years of his working life. If his investments are appreciating at a rate of Kes 15% per annum, at the end of 20 years he will have accumulated just under Kes 30,000,000 (inclusive of earnings). This sounds like a nice tidy sum for just Kes 20,000 per month doesn’t it? For arguments sake, let’s say between him and his employer, another Kes 10,000 has been going into pension every month and it returns an average of 15% p.a. This will then accumulate to about Kes 15,000,000 in the same period. I will ignore taxes for now so let’s assume he walks out of his job with a tidy total retirement sum of Kes 45,000,000. Looks enough for a comfortable retirement? Actually at a lifestyle cost of his current Kes 30,000 per month, he can actually survive on this for another 125 years. However this is not the formula for successful retirement planning. His current lifestyle of Kes 30,000 per month today will cost Kes 201,825 then because of inflation and that’s just assuming inflation settles at 10% per annum.
The amount of Kes 45,000,000 will actually cater for his costs for only the next 12 years. Remember inflation doesn’t stop because he is retired so the cost of his lifestyle will still continue to increase. Now back to my Principal vs. Interest introduction. Many people are currently eroding their principal to live off it just like John upon retirement. In fact many of us today are using our principal to increase our standard of living and paying interest to do it. We do this every time we liquidate savings/investments, incur debt or use our increased earning potential to increase our lifestyle as far as the material aspect is concerned. This decreasing principal, and in the wake of inflation, has decreasing power to produce interest or income. The dwindling capital becomes smaller and smaller until it can no longer provide for even our basic needs. John cannot sustain his lifestyle after year 12. He has reduced the production capability of his financial asset. This is akin to buying a house and taking it apart brick by brick.
Take Gillian with the same exact set of circumstances. At retirement she invests her money in a combination of government bonds, deposits and rental property. If her average interest or average yield (income return of an asset) is approximately 9% per annum (current return on treasury bills) she will be able to comfortably live off interest generated by the assets. By investing in government bonds and placing money in fixed deposits she has become the lender earning interest and not the borrower paying interest. The income that will be generated on a monthly basis will actually be Kes 337,500. This means she can sustain her current lifestyle (cost of Kes 201,825) and even continue re-investing the excess funds. This coupled with the fact that some of her investments can produce more income as their value grows (such as rental property) will help her keep up with inflation. Unlike John, she will not need to erode the value of her principal just to live.
Just like there are laws of nature, there are also laws of wealth creation that do not change. The law introduced today is invest (and continue reinvesting) principal and spend or live off interest or income. By not diminishing the value of your principal, you will continue to be able to grow its value. Also look at this principal in terms of your earning potential. Whilst it is there, use as much of it to grow so that eventually the interest or income earned from it can sustain you and your desired lifestyle.
Waceke Nduati-Omanga |waceke@centonomy.com | Twitter@centonomy
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