The two most important financial percentages

There are 2 financial percentages everyone should learn about. One of them is “Interest Rate” and the other is “Return on Investment (ROI)”. Both are usually given in percentages e.g. 1.5%, 4%, 12%, etc. However, most people do not know what these % means and how it is calculated. 

“Interest Rate” is referring to the cost of borrowing money. Interest Rate is what other people are going to charge us for using their money.

“Return on Investment (ROI)” is referring to the return from lending money to other people. ROI is what we’re going to get for other people using our money. 

The 3 types of Interest Rate most people are familiar with are:

  1. Personal/Car loan
  2. Property loan
  3. Credit card

The 3 types of ROI most people are familiar with are:

  1. Dividend/Rental Yield
  2. Capital Gains
  3. Fixed Deposit/Savings Interest

Interest Rate is what I’m paying other people, so I want it to be as low as possible.

Return on investment is what I’m getting from other people so I want it to be as high as possible. 

So far so good. 

The difficulty comes when we want to compare Interest Rate between different products. The differences can depend on:

  • Calculation method
  • Frequency of charging 

So a 4% car loan is not the same as a 4% mortgage loan is not the same as a 4% credit card rate. We need to ‘annualize’ the rate so that we have a result like:

  • Annualized Personal/car loan rate
  • Annualized Property loan rate
  • Annualized Credit card rate

Similiarly, the difficulty comes when we want to compare Return of Investment between different products. The differences can depend on:

  • Entry price/fees
  • Exit price/taxes/fees
  • Monthly income/maintenance fees
  • Investment period

So a 4% dividend/rental yield is not the same as a 4% capital gains is not the same as a 4% fixed deposit rate. We need to ‘annualize’ the rate and minus all costs so that we have a result like:

  • Annualized net of all fees & taxes Dividend/Rental Yield
  • Annualized net of all fees & taxes Capital Gains
  • Annualized net of all fees & taxes Fixed Deposit/Savings Interest

If and only if we master both these percentages, then we can make basic financial decisions intelligently like: 

  • which types of loans to pay off
  • which types of ROI to reject

Then we graduate to advance financial decisions like: 

  • which loans to take
  • which ROI to take
  • which loans to take for which ROI

Some calculators to play around:

http://www.calculator.net/interest-rate-calculator.html

http://www.calculator.net/auto-loan-calculator.html

http://www.calculator.net/interest-calculator.html

http://www.calculator.net/compound-interest-calculator.html

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One thought on “The two most important financial percentages

  1. Pingback: The two most important financial percentages – examples | life-lite

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