There are a few finance concepts you need to understand to manage your money well and grow wealth. I have picked 5 concepts that will give you a good foundation for your financial education and money mindset.
Table of Contents
Finance concept 1: Compound interest
Compound interest is one of the most important finance concepts you need to understand and applies to all aspects of personal finance. Compound interest is the interest added to the interest on a loan or investment. The compounding effect is basically earning interest on interest. Here are a few aspects of your finances that can be impacted by compound interest:
Spending
When doing a spending review, applying compound interest can help you understand why cutting your spending on “nice to haves”/”wants” is a good idea. For instance, if you get a manicure done every 2 weeks for £25 each visit, this results in a spend of £50 a month and £6000 over 10 years. If this is regularly invested monthly in a stock and shares ISA over 10 years at a projected growth rate of 5%, your investment could be worth up to £7265 according to this Hargreaves Lansdown’s calculator.
This might seem like a small amount but similar savings like the regular coffee shop visits or cutting down on take-outs could accumulate into a tidy sum. It is still good to treat yourself now and then so you can reach a good compromise. For example, you can cut down to 1 manicure a month or once every 3 months (To save more aggressively, I will do once or twice a year as a birthday or occasion treat and DIY other times). Imagine finding £500 worth of lifestyle savings a month, this will earn you interest and the interest will earn interest for years to come (provided you are reinvesting the interest). £500 a month over 10 years will be £72,645 of coffees, takeouts, manicures forgone.
KEY TAKAWAY
Consider the long term compounded gains your unnecessary spending could have earned you
Loans
If you have loans and your loan interest is applied on a monthly basis then the interest on your loan compounds faster. Let’s look at two scenarios:
- Scenario 1 – Interest cost of a £10,000 loan at 3% interest calculated annually is £300
- Scenario 2 – Interest cost of a £10,000 loan at 0.25% interest calculated monthly. Month 1 interest will be £25, month 2 interest will be on £10000+£25, and so on. Interest will be paid on the principal and accumulated interest. The total annual interest will be £304.16. This is £4.16 more than the annual cost in scenario 1. This is more significant if your loan or interest rate is high.
KEY TAKEAWAYS
If you are taking out a loan, check the frequency of the interest calculation. You will pay back more interest if the frequency of the interest calculation (compounding periods) is higher. Paying back the principal quickly will result in lower interest costs.
Savings
When you save, your savings accumulate interest which in turn earns interest. I almost forgot this the other day when I was setting up a new savings account. When asked if I wanted interest monthly or annually, I almost clicked annually absent-mindedly. I caught myself just in time. Just like the loan scenario, a higher compounding period earns you more. If the scenario above is flipped and you were saving £10,000 at the same interest rate, monthly interest will compound to give you £4 more at the end of the year. This will then continue to compound for the duration you save or invest. This is also more significant if rates and amounts saved were higher.
KEY TAKAWAY
If you have an option to receive interest monthly or annually, choose the monthly option.
Finance concept 2: Assets and Liability
Assets and Liability are accounting terms that are part of a balance sheet. It is easily one of the finance concepts you need to understand to be financially independent. A balance sheet is a statement of a company’s net worth. In the same vein, to calculate your net worth you need to know what your assets and liabilities are.
An asset is anything that you own that will generate future cashflow
A liability is everything you owe
Understanding these two concepts is important in helping you understand your money.
Robert Kiyosaki’s definition of assets and liability in the book Why is this important? the secret to financial independence is to buy real assets that generate cash flow and keep liabilities low.
The rich buy assets
The poor only have expenses
The middle class buy liabilities they think are assets
Rich Dad Poor Dad by Robert Kiyosaki
Finance concept 3: Budgeting
To achieve your financial goals e.g pay off debt and spend less than you earn so that you can save/invest what is left, you need a budget.
I highlighted this in my previous posts 4 steps to achieve financial stability. Some might say they have managed to achieve things and grow their wealth without a budget. Well, check again. Every organisation, big or small, will have an accountant and a budget or at least financial statements recording their spending. My post on introducing budgets and why you need a budget says it better.
You need to take this very seriously if you want to grow your wealth. Check out our ultimate guide to budgeting series and download the free budgeting spreadsheet below to get started.
Key takeaway:
A budget is crucial to understanding your spending and keeping it below your earnings so that you can save to reduce your liabilities or add to your asset.
Finance concept 4: Needs and wants
This is another very crucial one. Understanding what is a necessity and what is a want helps us keep spending low.
A need is something that you require to survive and live a healthy life
Example of needs
- Shelter
- Food
- Utilities
- Clothing
- Healthcare
Wants
Any “nice to haves” you can survive and live without
Examples of wants
- TV Subscriptions
- Take-outs
- Gym subscriptions
- Theatre/cinema
In addition, some needs become wants when they go beyond fulfilling the basic requirement. For example, you need clothing to cover your nakedness and keep warm but it doesn’t have to be designer clothing to meet the need for decency and warmth. The same applies to almost everything, for example how big a house do you need for shelter?
A car fulfills your need to move from point A to B. You don’t need a Ferrari to meet that need. A used car in very good condition will do the same job.
Does this mean you can’t spend money on wants? No, but as we discussed earlier, it is a good idea to limit your spending so that you have enough left to invest in assets. Then splurge on luxury items when your assets start to generate enough income to fund your lifestyle.
Many buy gadgets they don’t really need, with money they don’t have, for people they don’t actually care for, while infringing their corporeal and financial capacities, in order to pay doctors and psychiatrists. ( “Keeping up with the Joneses”)
Erik Pevernagie
Finance concept 5: Long term versus short term
There are many important financial concepts you need to understand to manage your finances better. I struggled with what to choose as number 5 but decided to talk about this one as it is not discussed that often.
I believe that there are times when short term responses are needed to resolve issues. One of the popular quotes that I learned while studying Economics as an undergraduate was spoken by John Maynard Keynes:
In the long run, we are all dead
John Maynard Keynes
Keynes is the father of the Keynesian school of economic thoughts and his quotes have been used as the basis for governments responding to a crisis or economic downturns. The interpretation is that you need to respond to immediate pressures and think short term because there might be no long term (we might all be dead). Currently, governments in the world are using borrowing and quantitative easing to tackle the current pandemic. The long term effects of this are yet to be seen.
However, when you are making plans or making decisions for now also consider the future impact, not just the immediate pressures. For instance, I am a believer that if you are struggling with debt or financially unstable, do everything you can to generate income with side hustles. See my post on boosting your income. However, some side hustles might not be sustainable in the long term so the idea is to invest in assets that will give you passive income in the long run.
Conclusion
Understanding and applying the above principles will change your perspective and help you manage your finances better. Please comment and let me know what you think. As always, spread the love and share this post with others. You never know how much difference it will make to their lives and finances.
Have a valuable week!