Why compound interest, not diamonds, is a girl’s (or guy’s) best friend

I found myself watching Pretty Woman again the other night (which incidentally, I think is a terrible film, though I am probably in the minority amongst the sisterhood here).

What struck me was that instead of flipping snails in posh restaurants, Julia Roberts’ character should have been learning a few share trading tips from top financier Richard Gere.¬†In fact, she could have asked him a few smart questions about how to run your own business.¬†Because, however nice the trinkets and the diamonds are, it is an understanding of the principles of finance, and particularly, the laws of compound interest, which would have kept her off the streets for the rest of her life. Once she’d learnt that, it wouldn’t matter whether or not he stuck around to pay the bills. She’d have all the skills she needed to manage money successfully.

Of course that wouldn’t have made much of a romantic chick-flick, but we are living in the real world here, so here are the facts:

1. When compound interest works in your favour, you are on a winning streak. When you receive interest in the form of savings income, dividend payments from shares, or from passive income, it accrues. Then you receive interest on the initial capital investment, plus the interest on top. Simple.

2. When you are on the wrong side of compound interest then it is easy for debts to spiral out of control pretty quickly. This is particularly the case at the moment where savings interest rates are still historically low, but the interest rates charged on loans are rising. Once you have a capital debt the charges you pay on that can accumulate very quickly, until it becomes difficult to pay off even the monthly interest, never mind the underlying initial debt.

So the bottom line is, manage your money successfully by thinking twice, if not three or four times, before taking on a personal loan or racking up credit card debt. The only debt you should really have is one which is being paid off for you by someone else, for example, a buy-to-let property.

Had Julia Roberts known that, she wouldn’t have needed to wait for her grumpy handsome prince to come waving the credit card and buying the fancy shoes. She could have done it all herself instead.