MONEY SECRETS that will set you up for life
To be a champion in what you do, you have to believe in yourself when nobody else will.
Why
money isn’t
boring
If you think money is a bit of a boring
subject, then consider this.
If you have money, you can do what you
want, go where you want and buy what you
want. Money is a passport to an easier and
more comfortable life. Money means
freedom.
In fact, the only boring thing about money
is not having enough of it.
Which is why you may find this information
interesting.
Because this blog is all about how to make
sure that you always have enough money.
The most important money secret in the
world
Crazy as it sounds, you don’t have to be
rich to always have enough money.
True, if you earn a huge salary or win the
lottery, it will be a great help.
But it isn’t vital.
Take an average couple living in the UK.
If you add up all the money they are likely
to receive during their lives (I am talking
about all the money they earn, their
pensions when they retire and so forth), it
would come to £2 million before tax.
£2 million is a lot of money. Managed
properly, it is enough to:
➜ buy a decent home
➜ buy several cars
➜ take dozens of overseas holidays
➜ enjoy all sorts of luxuries like nice
clothes and meals out
➜ pay all your regular bills
➜ feed yourself and your family
➜ retire early
➜ build up some savings.
Which brings us to the most important money secret in the world:
Having enough money has less to do with how much money you earn, and more to do with how well you manage your money.
What do we mean when we talk about ‘managing’ money?
Nothing complicated or difficult, just making sure that you:
➜ save a certain amount of your money
➜ borrow wisely
➜ don’t allow yourself to be ripped off.
What happens to people who don’t manage their money?
Lots of people don’t bother to manage their money. For instance, they might:
➜ spend every penny and never save
➜ borrow and end up in debt
➜ pay no attention to what things cost or whether they are getting value for money.
The trouble with this approach is that you can only spend your money once. Even if you are very rich, after your money is
gone, it is gone. If you have frittered it away, you won’t be able to get it back.
Not surprisingly, people who don’t bother to manage their money properly usually end up in the boring position of not having enough. Not having enough money gives you fewer choices about how you live your life. It means things like:
➜ working longer and harder
➜ living somewhere less nice
➜ having less to spend on the things you want.
Not having enough money almost always means worry, too. You may have noticed that the world is full of people who worry a great deal about money.
The sooner you start managing your money, the richer you’ll be
The younger you are when you start managing your money, the better off you are likely to become.
This is for the simple reason that in order to make your money grow you need to give it time. The more time you give it, the more it will grow.
Let me give you just one example of this.
Imagine you start saving £1 a day on your 18th birthday. This is what your savings would be worth on your important birthdays up until you reach the age of 60:
At 25 your £1 a day will be worth £3,461 At 30 your £1 a day will be worth £7,362
At 35 your £1 a day will be worth £13,093
At 40 your £1 a day will be worth £21,513
At 45 your £1 a day will be worth £33,886
At 50 your £1 a day will be worth £52,066
At 55 your £1 a day will be worth £78,777
At 60 your £1 a day will be worth £118,025
When you are young, it is quite tempting to think that there is no rush to manage your money. It is easy to imagine that you have plenty of time. But the longer you leave it, the more difficult it will be. Suppose that you want to have savings of £10,000 on your 30th birthday.
➜ You could save 78p a day from the age of 13.
➜ You could save £4.47 a day from the age of 25.
➜ You could save £27 a day from the age of 29.
Every day counts when it comes to making the most of your money, and it is never too early to begin.
Think yourself rich
If you want to greatly increase your chances of having enough money to do whatever you want with your life, then it is crucial to understand that there is a direct connection between:
➜ how you think about money
➜ how you treat money
➜ how much money you are likely to end up having.
This may sound obvious, but you only have to look around to see that many people just don’t get it. They lurch from finan-cial crisis to financial crisis because they don’t understand their own money beliefs.
Test your own money beliefs
Without necessarily being aware of it, you will already have developed a number of money beliefs. To get an idea of what these may be, read each of the statements below and tick the appropriate box.
Agree Disagree Not Sure
1. Money is there to be spent.
2. Money is easy to come by.
3. You should never borrow money.
4. Money – and what it buys – can bring happiness.
5. It is rude to talk about money.
6. It is important to spend money wisely.
7. There is nothing wrong with borrowing money whenever you want to.
8. Having to think about money is tedious.
9. You should never lend money.
10. Saving money is a waste of time.
11. It is sensible to shop around for the lowest prices.
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
12. Money is a constant worry.
13. Making money is satisfying.
❏ ❏ ❏
❏ ❏ ❏
Now consider your overall attitude to money. How would you describe yourself?
Yes No Not sure
Good with money
Bad with money
Sometimes good/sometimes bad
❏ ❏ ❏
❏ ❏ ❏
❏ ❏ ❏
There is no point in scoring this exercise, because there isn’t a right or wrong way to think about money. But certain beliefs are going to make it harder for you to manage your money well. For instance, if you ticked the ‘agree’ boxes next to the following three statements:
‘Money is there to be spent.’
‘There is nothing wrong with borrowing money whenever you want to.’
‘Having to think about money is tedious.’
then you aren’t likely to be doing yourself any money favours.
Make money your friend
So what should your attitude to money be if you want to be better off? In a word: positive. You need to see dealing with money as something enjoyable, something that is worth the effort. It should be part of your life, not a chore.
It may help if you think of money as if it were a close friend:
➜ Show it respect: don’t throw it around or throw it away.
➜ Give it time: don’t rush money decisions or expect quick results.
➜ Look after it: don’t neglect or ignore anything to do with your money.
If you know that you are bad with money or erratic (some-times good and sometimes bad), then the best way to improve your behaviour is to change the way you think.
How to change your money beliefs
Money beliefs tend to be strongly held. This is why people find it so hard to break bad money habits. It is also why money is frequently the cause of arguments between friends, relatives and – especially – couples. This isn’t surprising when you think about it. For instance, if one person in a relationship takes a responsible attitude to money while the other person is reck-less with it, trouble can’t be far behind.
Your attitude to money doesn’t come from nowhere. It will be the result of a number of different influences, including:
➜ your money experiences: if you have had to make do without much money, you are likely to be considerably more careful with it
➜ your parents’ attitude to money: you may share your parents’ approach to money or you may reject it, but either way it will influence you
➜ the mystifi cation of money: there seems to be a general conspiracy to make money as complicated a
subject as possible (it is not helped by the fact that we aren’t taught much about money at school)
➜ society’s attitude to money: in Britain it is generally considered rude to talk about money or spend too much time looking after it.
If you want to alter the way you think about money, try to identify the source of your beliefs. Armed with this informa-tion, you’ll find it much easier to change your attitude.
It is the thought that counts
Human beings, like animals, are creatures of habit. Once we start behaving in a certain way, we often go on repeating it.
Let me give you an example. When I first started work, I used to spend every single penny of my pay within hours of receiving it. I meant to save something, but somehow I didn’t. Afterwards I would swear to myself that next week it would be different. But it wasn’t.
The more times we do something, the harder it is to change. What is the solution? If you find it difficult to change the way you are behaving, start by trying to change the way you think. How can you change the way you think? One method is to repeat the thoughts you want to have over and over to yourself. It sounds silly, but scientists have proved that it works. Another method is to learn everything you can about whatever you are doing because, as a philosopher called Francis Bacon once said, ‘knowledge itself is power’. So if you read this book it will help you develop positive money thoughts that, in turn, will help you
develop positive money habits.
Don’t let money faze you
Money is one of those subjects that people seem deter-mined to make more complicated than is necessary.
In fact, pretty much everything you need to know about looking after your money falls into one of four very simple areas. These are:
1. saving and investment
2. borrowing
3. insurance
4. money management.
Understand what each of these four areas involves and you’ll find that nothing to do with making money deci-sions ever fazes you.
Can money make you happy?
Do you wish you had more money? You aren’t alone. But would having more money actually make you happy? And, assuming your answer is ‘yes’, how much more do you actually need? These questions may not be as stupid as they sound.
There are plenty of good reasons to want more money. It is, after all, absolutely essential to our lives. We need it for:
➜ survival: how would we pay for food, clothes and somewhere to live if we didn’t have money?
➜ improving our circumstances: for example, if we want an education or to buy our own home, we must have money
➜ luxury items: money pays for all sorts of things – from mobile phones and meals out to holidays and multi-media systems – that make life more pleasant
➜ looking after others: we need money to support our families, to give to charity and to help other people.
In addition, money offers us a number of extra benefits.
These include:
➜ a sense of security: it is human nature to worry about survival – even wealthy people are sometimes concerned about it – and having plenty of money goes a long way towards making us feel more secure
➜ respect: society looks up to people with money – life is much easier for them
➜ power: not only does money buy things, it buys influ-ence – the richer you are, the easier it is to get your voice heard where it counts.
As money is so valuable to us, it stands to reason that the more we have of it, the happier we will be. Or does it?
‘Result happiness’
In David Copperfield, which Charles Dickens wrote over 150 years ago, the famous character Mr Micawber says:
Annual income twenty pounds, annual expenditure nine-teen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
Money was worth a lot more in those days (imagine being able to live on £20 a year!) and people used pounds, shil-lings and pence (instead of just pounds and pence), but the point being made is timeless:
If you spend more than you earn, even if it is only sixpence, the result is misery. If you spend less than you earn, again, even if it is only sixpence, the result is happiness.
So, according to Dickens, happiness isn’t necessarily to do with how much money you have, but whether you live within your means.
The best things in life are free
What on earth could be better than being rich? Here are just some of the things that money can’t buy:
➜ Good health: there is no point in being wealthy if you can’t enjoy it because of poor health
➜ Love: it goes without saying that no amount of cash will make people love you
➜ Friendship: anyone who likes you only because of your money isn’t a real friend
➜ Self-worth: having money and all that it can buy won’t actually make you feel good about yourself – this comes from inside you
➜ Peace of mind: if you are worried about something, or suffer from depression, having a fat bank balance won’t make any difference.
It all comes down to one simple truth: the best things in life are free.
What monkeys have to teach us about money
In the 1930s, an American psychologist called Abraham Maslow was doing experiments with monkeys and noticed something very interesting. If the monkeys were both hungry and thirsty and they were given a choice of food or drink, they always drank first. He realised that this was because monkeys, like people, can live for weeks without food but will die within a few days without water. He then found that if the monkeys were hungry and were offered a choice of food or of spending time with another monkey
they liked, they opted for the food. This got Maslow thinking about human behaviour. He concluded that our most important needs are physical – that is to say air, water, food, shelter, clothing and so forth, largely the things we must have if we aren’t going to fall ill or drop dead. He then went on to list the other things humans need and in what order. For instance, he suggested that the need to live somewhere safe and secure was more important than the need to be loved. The fascinating thing about Maslow’s findings is that only a few of the human needs he identi-fied can be bought with money.
Too much of a good thing
Have you ever eaten so much of something you like that you felt sick? Or played a particular piece of music until you were fed up with it? Or done something you enjoyed so many times that you ended up being bored with it?
It is possible to have too much of a good thing – and this includes money.
Too much money can lead to dissatisfaction, boredom and depression. It can also make people spoilt so that they behave badly – something you may have witnessed.
There is a saying: be careful what you wish for. It is a reminder that you may be sorry if your dreams actually come true. Having enough money to meet your needs and do what you want is obviously wonderful. Having more than enough may not make life any better.
How much is enough?
Warren Buffett, one of the richest people in the world, with a fortune worth roughly $52 billion, lives in an ordinary house, drives an ordinary car and takes ordinary holidays.
He could buy just about anything he wanted – private planes, big yachts, enormous mansions, fast cars, jewellery
– but instead he has chosen to lead a relatively simple life and to give most of his money away to charity.
Only a very few people ever have the range of choices open to someone like Mr Buffett. But we still have choice. How much effort will we put into making money? How will we spend it when we start to earn it? Only you can decide what is right for you. However, there is an expres-sion you may like to bear in mind in relation to money: you can’t take it with you when you die.
Strike a balance
We must have money to survive. It also makes all sorts of things possible, such as the ability to help other people or live somewhere nice or travel. But there are lots of very important needs – health, love, friendship and feeling good about ourselves, to name a few – that money can’t buy. And having too much money may actually make us bored and fed up.
1 The only boring thing about money is not
having enough of it.
2 Think of money as a close friend. Respect it.
Don’t rush money decisions. Look after it.
3 Happiness isn’t necessarily about how
much money you have, but about whether
you live within your means.
A very, very short history of money
If you were an early Pacific Islander, you would have used cowrie shells. If you were an Aztec, you would have used cacao beans. If you were an ancient Roman, you would have used salt or, for bigger items, perhaps slaves. Nowadays, of course, we use notes, coins, bits of paper, plastic cards and information technology.
Over the last few thousand years, money may have changed beyond recognition but the reason we need it, and the principles upon which it is based, haven’t. Which is why learning about the history of money will help you to make the most of your own.
It began with barter
If you were asked to name some great human inventions, what would you choose? The wheel? Electricity? The telephone? The chances are that you wouldn’t mention one of the oldest and most advanced technologies devised by humanity: money.
Money began with barter. A fisherman, for instance, might exchange some of his catch for fruit or a hunter might exchange an animal skin for spears.
The trouble with such a primitive system was that it took a lot of time and effort. You had to find someone who wanted to swap with you and then you had to work out a deal.
So most societies developed what the dictionary calls a ‘medium of exchange’, which is what we think of as money.
How does money actually work? Let’s consider the cowrie shells favoured by the early Pacific Islanders mentioned above. A fisherman living in that part of the world might exchange (or sell) a bag of fish for, say, ten cowrie shells. He might then swap the cowrie shells for all manner of items, as and when it suited
him. For instance, he might use three cowrie shells to buy fruit, two cowrie shells to buy meat and one cowrie shell to buy a new grass skirt, keeping four cowrie shells in reserve for later. Cowrie shells obviously make buying, selling and saving much simpler for him. Furthermore, they are easier to carry around and, unlike fish, they won’t go off.
Money only works when
people believe in it
The whole cowrie-shell-as-money thing can only succeed, of course, if the shells are in short supply. If you could just walk along a beach and pick up handfuls of them, then the whole system would fail. After all, you would have to be a very stupid fisherman to swap your catch for something that was easy to get hold of.
Ever since money was invented, countless governments have been tempted to increase its supply in order to have more to spend. Once paper money became popular, a government could do this simply by printing a bit extra. However, it is not a policy that ever works for very long. As soon as people realise what is happening, the money quickly loses its value. Confi-dence is a vital factor in any money system.
Money should be measured in time and effort
It is not what money is made from but what it represents that makes it valuable.
Generally, it represents labour. In the case of our early Pacific Island fisherman, he built a boat, made a net and went fishing. So it was his time and effort (his labour) that he was swapping for cowrie shells, and when he spent those cowrie shells it was his time and effort (his labour) he was spending.
To put this in a modern context: if you work for someone in exchange for money, and then exchange the money for food, you are, in effect, exchanging your work for food.
The money itself – whether it is cowrie shells or gold coins – has no real value.
The gold and silver age of money
The connection between money and two precious metals – gold and silver – goes back thousands of years.
The first coins were probably stamped ingots of ‘electrum’, a mixture of gold and silver, created by the Lydians, a people of Asia Minor, in about 650 BC. The most famous Lydian was King Croesus, who introduced pure gold coins and was the inspiration behind the expression ‘as rich as Croesus’. Gold and silver coins rapidly spread in popularity because they made trade – and especially international trade – so straightforward. It was silver coins, for instance, that the Romans used to fund the expansion of their empire. Interestingly, several countries were still minting their coins from silver until the middle of last century.
Why aren’t banknotes and coins backed by gold and silver any more? Because governments found it incredibly restric-tive. A country could be doing really well but, if it didn’t have enough gold, this would not necessarily be reflected in the value of its money.
If gold and silver, like cowrie shells, cacao beans, salt and slaves, are no longer used as money, then what is? The answer, as I am about to explain, is: nothing you can actually put your hands on.
We will soon be living in
a cashless society
In developed countries, just one-tenth of money takes the form of banknotes or coins. The rest – nine-tenths – is ‘electronic money’, that is to say it exists only as numbers in bank accounts. So, we have reached a point where not only are banknotes no longer backed by gold, but most money isn’t even backed by banknotes. Instead, when one person or organisation wants to pay another, they transfer the ‘money’ electronically. This money doesn’t even exist on paper.
We are moving rapidly towards something that has been
called the ‘cashless society’. How long can it be before we stop using cash for anything and instead rely on personal identi-fication numbers (PINs), passwords, ‘smart’ cards and other technology? Probably not that long.
1 Money is one of the greatest human
inventions ever.
2 It is not what money is made from but
what it represents that makes it valuable.
What it represents is human time and
effort.
A cunning money plan
What do you want from life? A home of your own? A nice car? Lots of holidays? Enough money to be able to give it away to others less fortunate than yourself?
Thinking much more short term, what would you like? Clothes? Music? The latest mobile phone? An MP3 player? A computer?
Whatever you are hoping for, you need to get yourself from where you are now to where you would like to be.
The fastest and easiest way to get from one place to another is to have a plan. For example:
Imagine you have decided to drive your brand-new sports car through France from Calais to Cannes. You wouldn’t just take the fi rst road you saw and hope that it was going in the right direction. You would plan your journey before you set off – perhaps to include interesting sights. If you hit problems (such as traffi c delays) during the trip, you would get out your map and fi nd a new route. During your journey, you would check your progress.
A ‘money plan’ works in exactly the same way. It will help you reach your destination in the shortest time and with the least effort. Plus, it should make your journey enjoyable.
What does a money plan look like?
Your money plan could be as straightforward as a single piece of paper on which you have jotted down a few notes.
It is important to write it down, though, so that you can refer to it again in the future. A money plan can be:
➜ for any period of time, from a few days to a few decades: you might use a money plan for big things (such as buying your own car) or little things (making sure you have enough cash for a special treat next month)
➜ simple or complicated: you might use a money plan to achieve just one thing (such as making sure you have enough money to buy a computer) or a whole range of things (building up savings for a rainy day, making sure you have money to go to college or even buying your own home).
Anyone, of any age, can (and should)
have a money plan
Some people might say that you are too young to be thinking about ‘financial planning’, which is the technical name for writing a money plan. Rubbish. The second that anyone, of any age, has money of their own, they can and should start planning how best to use it in order to get what they most want. This even applies to a five-year-old given a few pence as pocket money.
Your must understant the language of money today.
‘Gearing’ has nothing to do with cars. It is a way of turning a small amount of money into a very, very large amount of money. For instance, with gearing you might turn £100 into £1,000. It is also a perfect example of one of the most off-putting things to do with money: the language.
Like any other area of life – for example computers or music
– money has its own language, or jargon.
Jargon is useful, of course, if you understand the words involved but confusing if you don’t.
Which is where this chapter comes in. Because it takes the most important and frequently used money terms and explains them in plain English. In fact, once you read this chapter you will know more about financial terminology than the vast majority of people in the UK. Money words you’ll understand the meaning of include:
➜ percentages
➜ interest
➜ compound interest
➜ inflation
➜ capital
➜ income
➜ gearing.
Once you understand these words, you’ll be in a considerably better position to make more money from your money.
Words to stop you being ripped off
There is another reason to learn a few key money words: it will be much harder for anyone to take advantage of you. When you come to make financial decisions and to buy financial products, you’ll find that understanding all the jargon will ensure you aren’t ripped off.
Getting to grips with percentages
Speaking of being ripped off, one way to prevent it is to make sure that you are getting value for money. And one way to make sure you are getting value for money is to make sure you know how to work out percentages.
The word ‘percentage’ literally means ‘parts per 100’ – cent comes from the Latin word for ‘100’. Because percentages always deal with parts per hundred, they allow you to compare things that would be very difficult to compare otherwise. They are particularly useful when it comes to deciding whether some-thing is better value (or more profitable) than something else.
When we want to write ‘percentage’ quickly, we use the symbol %.
How do percentages work? The first step is to take the numbers involved and turn them into a fraction. Next, you divide it out. Finally, you multiply by 100.
Let’s look at a really simple example. You have 25 bars of chocolate. Of these, 22 are Mars Bars. How can you express this as a percentage? The fraction is:
22 (Mars Bars)
25 (total number of bars of chocolate)
When you divide this out (22 divided by 25), you get the answer 0.88. When you multiply it by 100, you get the answer
88. So 88% of the bars of chocolate are Mars Bars. Let’s look at a more useful example.
Imagine that you have three apple trees and want to know
which one of the trees produces the highest number of good
– as opposed to rotten – apples. When you harvest the apples from each tree, you keep a note of the total number of apples picked and the number of apples that have to be thrown away. Your note looks like this:
Tree Apples on tree Rotten apples
A 750 150
B 550 88
C 670 101
Clearly, from the above figures it isn’t easy to gauge which is your best tree. However, if you express the figures in percentage terms, it will immediately become obvious.
On Tree A, 150 out of the 750 apples were rotten. So your calculation would look like this:
150 x 100 = 20%
750
If you were using a calculator, you would key it in like this:
150 ÷ 750 = 0.2 x 100 = 20%
For Tree B, 88 apples out of the 550 were rotten, so the calcula-tion would be like this:
88 x 100 = 16%
550
For Tree C, 101 apples out of the 670 were rotten, so the calcu-lation would be like this:
101 x 100 = 15%
670
Converting the numbers to percentages allows us to make a fair comparison of the performance of the apple trees. Of the apples on Tree A, 20% were rotten; 16% of the apples on Tree B were rotten; but just 15% of the apples on Tree C were rotten
– making it the best-performing apple tree in the orchard!
It is hard enough comparing apple trees with apple trees – but
even harder to compare apple trees with, say, orange trees. This is where percentages come in so useful. By giving everything a base of 100, we can compare things that aren’t alike in other ways.
Interesting, very interesting
The money term ‘interest’ is used to mean one of two things. First, it is used to describe the money you earn when you
invest in a bank account or some other sort of financial product. For instance, if you put £100 into a bank account and the bank paid you £5 a year, this would be called ‘£5 interest’.
Secondly, it is used to describe the money you pay if you take out a loan. For instance, if you borrow £100 and the bank charges you £10 a year, then this would be called ‘£10 interest’.
You will have noticed that in the two examples I have just given, you pay more interest to borrow £100 than you will earn if you invest £100. This is how banks make their money.
Interest is normally expressed as a percentage. If you invest £100 and get £5 a year in interest, this is called ‘5% interest’.
The genius of compound interest
When you are earning it, it has the power to make you very rich. When you are paying it, it has the power to make you very poor. Albert Einstein described it as ‘the greatest math-ematical discovery of all time’. It is the reason why banks, building societies, credit-card companies and other financial institutions make so much profit from lending money. And it is the reason why ordinary investors can make themselves rich simply by doing nothing. It is a fiendishly simple concept called ‘compound interest’.
Perhaps the easiest way to understand compound interest is to look at a hypothetical example.
➜ Imagine that you have £100 and that you invest it in a bank savings account that pays interest at a rate of 10% per year.
➜ At the end of one year, you will be entitled to £10 interest.
➜ If you withdraw the interest (in other words, take it out of the bank) but leave your original £100 untouched, at the end of the second year you will be entitled to another £10 interest.
➜ Supposing, however, that you don’t withdraw the interest but leave it to ‘compound’, or grow. At the end of your first year, your £100 is worth £110. At the end of your second year, you will have earned another £11 interest, meaning that your original £100 is worth £121 (£100 + £10 interest = £110 after one year. £110 + £11 interest = £121).
➜ Put another way, your interest is earning you more interest.
In other words, when you leave your money to earn interest
– and then leave your interest to earn more interest – that’s compound interest.
When you invest money and leave it to earn compound interest, it grows much, much faster. If you were saving £50 a month for 10 years at 8% a year, and you left the interest to compound, you would have £9,208. Not bad, considering you would only have put in £6,000.
Remember, though, that when you borrow money compound interest is working against you. Why? Because you are paying interest on the interest you owe. Suppose, for instance, you borrow £1,000 on a credit card at an interest rate of 15% – which isn’t high by today’s standards. The credit-card company allows you to make a minimum payment of £5 or 2% each month – whichever is the higher – and this is what you do. Not only will it cost you £550 in interest to repay your debt this way, but also it will take you a staggering 9 years and 10 months to do so.
Compound interest is your biggest money enemy and your biggest money friend. When you are in debt, it works against you. But when you have money to invest, you can make compound interest really work for you.
Inflation: a few words of warning
What your money can buy changes all the time. In 1981 a Mars Bar cost 15p. In 2006 a Mars Bar cost 44p. Why should this be? What difference does it make?
The word used to describe increases in prices is ‘inflation’. There are different sorts of inflation. House-price inflation is when houses cost more than before. Wage inflation is when people have to be paid more. General inflation is when pretty much everything – especially shopping – costs more. All infla-tion is measured in percentages.
At the moment inflation isn’t really an issue. Prices do go up every year but only by a tiny percentage.
In the past, though, inflation has sometimes gone mad. There have been years when prices have gone up by 10% (in other words, something costing £1 costs £1.10 just 12 months later) and more.
When this happens, your money is obviously worth less. This is quite important when it comes to your general level of wealth. If, every year, the value of your money is being eaten away by inflation, you could quickly find yourself much less well off. This is particularly true with regard to your savings. If a bank is paying you 3% a year interest but inflation is running at 2.5%, your money is only growing in real terms by 0.5% a year. Not much!
When you make any money plans for the future, you ought to bear in mind the effect of inflation.
What is capital? What is income?
One of the most important money concepts to understand is the difference between ‘capital’ and ‘income’.
Capital is something – it could be money, a property, shares or some other investment – that generates an income for whoever owns it.
A good way to remember the difference is to think of a fruit tree. The tree itself is the ‘capital’. The fruit it produces is the ‘income’. You continue to own the tree (capital) and it continues to bear fruit (income) every year. Your wage or salary is the income that comes from the capital of your labour – hence the expression ‘human capital’. Money is not just money – it is either capital or income.
When you own capital and it produces an income, you have a number of choices:
➜ You can hold onto the capital and spend the income.
➜ You can hold onto the capital, add the income to it (turning it into more capital) and generate even more income.
➜ You can spend some or all of the capital and thus reduce the income you receive.
There are lots of different names for the income produced by
capital. In the case of property, for instance, it is called ‘rental income’. In the case of a cash deposit in a bank, it is called ‘interest’ (see above).
Letting other people make you rich
Using borrowed money to buy an ‘asset’ (something that can make you more money) is called ‘gearing’. If you can make it work in your favour, gearing can dramatically boost your profits. For instance:
Suppose you buy a £100,000 fl at using £10,000 of your own money and a £90,000 home loan. After one year, the fl at is worth £130,000. It isn’t just that you have made a £30,000 profi t
– you’ve actually trebled the £10,000 you origi-nally invested. In other words, you’ve achieved a 300% gain in just 12 months.
Even if you allow for the cost of borrowing the £90,000 for a year, you have still done very well. However, what goes up can also come down. In the UK between 1987 and 1989, house prices fell by around one-third. If this happened to someone selling a flat they bought for £100,000 using a £90,000 mort-gage, they would not only have lost their £10,000 deposit but also owe an additional £23,333 or so (the difference between the home loan of £90,000 and the £66,666 they can sell the flat for). When this happens, it is called being ‘in negative equity’.
Gearing is the easiest and most effective way of increasing the potential profi t from any investment. It is also the most effective way of increasing the potential loss, something every investor thinking of gearing would be well advised to remember.
Without gearing, most people would never be able to own their own homes. It can also allow them to make other profitable investments. Nevertheless, you should think carefully before you make any investment that requires you to borrow money. You want to make sure that the investment is going to earn you more than the loan is going to cost you to repay.
Don’t trust your calculator
When you are working out things like percentages, don’t always believe the answer the calculator gives you. Why not? Because the tiniest slip of your finger could give you a completely wrong answer without you being aware of it.
Here are five things you can do to avoid calculator error:
1. Estimate your answer before you begin a calculation.
2. Do every calculation twice.
3. Know your calculator.
4. Don’t be overawed by your calculator.
5. Hang onto common sense and what you know.
1 Once you understand the concepts
explained in this chapter, you’ll be in a
considerably better position to make more
money from your money.
2 Percentages allow you to compare things
that would otherwise be very difficult to
compare.
3 Compound interest allows you to make
yourself richer without doing a thing.
4 Gearing – using borrowed money to make
money – can dramatically boost your
profits, but is sometimes risky.
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