By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

07 June 2015

Money matters always get people excited; and so it was when I wrote the piece explaining why you should not keep money in a savings account. I got very many questions from readers and I answered most of them in the follow-up articles. But James Wainaina wanted to know what difference it makes when interest is compounded.

Suppose you put your Sh50,000 in a fixed deposit account for one year earning a generous 6 per cent per annum. At the expiry of the period, you will get Sh53,000. I have assumed that the 6 per cent is net – that is, after withholding tax.

If the same money was in a Money Market Unit Trust also earning a paltry 6 per cent, the calculation would be done in the following way. First the 6 per cent per annum is divided by 12 to get the monthly rate. This comes to 0.5 per cent per month.

So, in the first month, you would earn Sh250 and this would be added to your account making it Sh50,250. In the second month, the 0.5 per cent interest would be calculated on the Sh50,250 balance. This works out to Sh251.25. So the new balance is Sh50,501.25. This is the amount used when working out the earning of the third month; thus: Sh50,501.25 x 0.5 per cent = Sh252.51.

Clearly, the interest amount is increasing in every subsequent month even though the rate remains constant. By the end of the year, the balance in your account will be Sh53,083.89. That is, you get Sh84 more even though the interest rate is the same.

Now let me make one point very clear: most Unit Trusts pay much higher rates than bank fixed deposits. I only used the 6 per cent to illustrate the difference between simple and compounded interest rates.

You can easily get above 9 per cent without making any special negotiation! This would earn at least Sh375 per month for your Sh50,000 making more than Sh4,500 by the end of one year. Now compare that with the Sh3,000 from a fixed deposit and ask yourself why you are keeping the money in the bank!

Another reader who prefers to remain anonymous asked why I am “screaming so much about the meagre 10 per cent interests while you can easily get more than double that by investing in real estate. Who has paid you?”

There is a difference between savings and investments: you save money in order to invest it later! If you can only put aside Sh10,000 per month, which plot of land will you buy? You probably need at least Sh100,000 to buy a small parcel.

In other words, you must save for at least 10 months. This is where the Unit Trust comes in. Instead of accumulating your month Sh10,000 in the bank, move it to the Unit Trust and you will easily earn almost Sh2,000 extra by the time you are ready to buy the plot. No bank will give you such a return!