A Quick Guide to Gearing, Compound Interest & Return on Investment (ROI)

Manipulation of the concept of compounded interest is what makes investors successful.

Compound interest is often referred to as interest on interest because that is how compounding works. A simple example... R1000 is invested for 1 year at 10% interest (ie 10% per year NOT 10%/12 per month) then on day 1 of the next year the sum invested has become R1,100. At the end of the second year the sum invested is R1,100 + 10% = R1,210.

If you project this over a 7 year period the amount invested at the end of year 7 would be R1,948.71 ... roughly double your initial investment.

Interest Rate to Double Invested Sum

Here's a very basic rule of thumb to calculate the interest rate required to double your money in a specified period of time:

Compound Interest rate to Double Sum Invested = 70/years

In the above example if we wanted to double our money in 7 years then compound interest rate would need to be 70/7 = 10%

Conversely if we were investing at only 7% it would take 70/7 = 10 years to double our money.

Compound Interest Daily or Monthly

It is a good idea to invest in a scheme that applies compound interest daily in order to get the benefit of compounding. For example if an interest rate of 10% compounded daily is provided then an initial R1000 investment at the end of year 1 would not be R1,100 it would be R1,105.16 This is equivalent to an annual rate of 10.516% not 10%. This number might sound quite small but when projected over a long period of time the compounding effect is enormous.

For example a R1,000,000 investment for 10 years is as follows

• 10% simple interest per year Final value = R2,593,740
• 10 Interest per year compounded daily = R2,717,900...
• A difference of about R125,000... not to be sneezed

A concrete example of how you can use this principle in reverse is if you have a bond on which interest is compounded daily but applied on last day of the month then it would be to your advantage to pay your bond at the beginning of the month rather than wait until the end of the month.

Return on Investment

You can deposit money in a bank and get about 6% compound interest. Your return on investment is then 6%.

If you have spare cash then it pays to look around for an alternative place to put your money whilst maintaining security. If you dont have an urgent need for the money then invest the money in a call account ... this means you have to give notice that you want to withdraw money. A call account will typically have a higher return on investment than a normal bank account.

The above is a very simple example of return on investment.

When it comes to calculating return on investment for a property there are many factors to be taken into but ultimately it boils down to the same calculation. Things get really interesting when money is borrowed (say 90% of the total sum required) to pay for a property at an interest rate which is lower than the return on investment (capital growth and income together). Quite simply you as the property owner are getting the benefit of growth on the full investment value (which is higher than the interest rate you're paying the bank) but you've only invested 10% of the value of the investment. This principle is called gearing.

Gearing can go horribly wrong as we've witnessed with the global meltdown ... too much money borrowed and low returns (losses in fact) on the major investments made. Thus cash was not available to meet the interest payments required to service the debt or borrowings.

Before becoming heavily geared you need to be quite sure you have enough cash flow to service the debt. This is why being able to compute various investment scenarios is important.