The devil is in the detail
One of the principal reasons investors lose money is because they chase after unrealistic returns on their investments, whether it be in equities, bonds, unit trusts, real estate or another asset class.
Those who have been affected by such losses, often opt for an ultra-cautious alternative, like a fixed rate bank deposit. Not only are their returns fixed but they can also make use of SARS’ interest rate exemption.
However, when quoted in isolation, the percentages offered often are often not without conditions. As they say, the devil is in the detail and if you do not read the fine print carefully, a product offering 13% can earn you less than one offering 11%.
The extraordinary power of compound returns
Albert Einstein called compound interest the eight wonder of the world, saying “He who understands it, earns it… he who doesn’t… pays it. Compound interest is the most powerful force in the universe… the greatest mathematical discovery of all time.”
The basic concept of compounding is simple. In the first year of investing, you may generate returns on your initial investment. In the second year, you invest the capital (your initial investment) plus the returns, and you generate further returns on the total. If you repeat that year after year, your returns will generate returns.
Consider the chart below. Two investments of R100 000 are made on the same day. The one at 13% nominal interest and the other at 10% compound interest. While the 13% nominal option initially provides greater returns, the effect of compounding very soon outpaces the higher rate. After twenty years, the investment values will be R360 000 and R672 750 respectively.
Terms and conditions always apply
Why this discrepancy? Look at the asterisk next to the 13%, which takes you to the fine print stipulating that the offered rate is subject to terms and conditions.
While all the numbers are quoted correctly, it is calculated at a nominal rate. When compounded, the rate of return is only 10.53%. And if you want to have the interest paid to your bank account monthly, the rate drops to 10%. And then there are still bank charges to be paid.
In addition to this detail, the Ts & Cs warn that there are penalties to be paid for redemption before the end of the five-year period.
Take a holistic view
Another complication is the effect of taxation. In an ironic twist, it often happens that a higher interest rate can move an investor to a higher tax bracket than might be anticipated.
This supports the necessity of a holistic view before committing to an investment product.
SARS applies an annual interest rate exemption of R23 800 for people under 65 and R34 500 for those over 65 years. In other words, any interest which exceeds the exemption amount, will be added to your taxable income and taxed accordingly each year.
Dividend Withholding Tax
A further alternative is to invest in products offering a dividend return. Like the nominal interest paying investments, these investments pay a nominal, not compound return. On the upside, dividend withholding tax only amounts to 20% of the dividend income earned.
Look at the fine print
Few investors are able to determine the full tax exposure in respect of their investment choices. A qualified and accredited investment adviser will help you take a holistic view of tax and investments, which will play a significant role in your wealth generation activities.