Adoption Arena asks Jacob Rees-Mogg MP for Somerset and finance expert to share some insights into the issue of ‘money’. I always say if your going to ask for advice, get it from the top. ‘Tiers of debt’ explained quite simply delivers understanding into an area of life that many of us find ourselves in, sometimes through no fault of our own.
Albert Einstein called compound interest the eighth wonder of the world. It is the most important fact for anyone dealing with money to consider and less complicated than it sounds. It affects everyone who saves or borrows and understanding it can help people arrange their finances.
Compound interest is the normal way in which money is paid for, interest is not only charged on the initial amount borrowed but on the accumulated interest as well. In this way someone who borrows £100 and pays 10% interest will after seven years owe £194.87 not £170 that would arise if only the initial debt incurred a charge.
This is important for people’s personal finances as credit card charges mount very quickly and pay day lending spirals out of control almost immediately. Barclaycard offers a number of credit cards but at its highest rate of 34.9% a £100 debt will have doubled in a little over two years. Its next offering at 25.9% will take just over three years to reach £200. This shows both the sensitivity of a debt to the interest rate and the speed with which it can grow. As a rule of thumb, factors of seventy double so a 3.5% rate of interest will take twenty years to double but a 20% interest rate will do so in three and a half years.
The lesson of this is that it is almost always right to pay off or avoid debt. Interest rates paid to depositors are always lower than the rates charged to borrowers. A savings account paying 1% would not be atypical and would take seventy years to double in comparison to the two years mentioned above.
This is not to say that saving is pointless. It is a sensible thing to do and the returns are usually better than those currently available. However, savings ought to be used to pay off debt as only the most speculative investments ever return enough to keep up with the cost of unsecured borrowing. This is because of the risk. Unlike a mortgage it is not secured to a property so the bank cannot be certain that the money will be repaid. Inevitably the risk of default is then put into the interest rate.
Mortgages are different, although the rates remain higher than for deposits, the margins are smaller. This is partly because of the lower risk but it is also because of the reduced administrative burden. The amounts involved tend to be quite large and the period of the loan may be over twenty five years. This is, therefore, a preferable form of borrowing to credit card debt.
To return to Einstein, he said of compound interest “he who understands it, earns it… he who doesn’t, pays it”. It is the essence of all financial transactions and remembering it helps build a clear hierarchy of money. The best position to be in is to have savings and no debt; next comes a mortgage, then credit card loans and at the bottom of the pile, to be avoided if at all possible, comes pay day loans. In turn each level ought to be used to repay the level below so savings to reduce a mortgage, mortgage to replace credit cards and if the need arises, credit cards to replace a pay day loan.