How to make a loan earn you money

 

electric shock

From time to time, I geek out on spreadsheets, especially when I think I can prove  a bogus idea wrong.  On my recent cruise to Alaska, while the missus and kids snoozed, I would rise early, hit the library, and …. work on spreadsheets for the heck of it (see: geek).

I decided to tackle a “fact” I had been presented with, that my philosophy of saving instead of taking out loans on big ticket items wasn’t smart.  I was told I’d be better off investing the money I saved, and taking out loans for the larger purchases, even if the loan was 1-2% higher than my investment yield.

How does that make sense??

I decided to run the numbers to confirm and – holy crap, the guy was right!

Here’s how it works:

Say you want to buy a car for $12,000. You:

  1. Save $250 a month for 4 years. That gets you the $12,000, before any earned interest.
  2. If you save your money in a bank, let’s say your yield is 1% (I know it’s usually less, but let’s go with this for now).

At the end of the 4 years, you would have $12,248.49. So far so good.

But what if you were offered a loan for 5 years for the same amount at 2%?

The 2% loan would cost a lot more than the 1% you’d be earning, right?

Right?

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Let’s say we let the $12,248.49 ride for another 5 years at 1% annually. This becomes $12,876.22, compounded.

At the same time, we borrow $12,248.49 from the bank, also for 5 years, at 2% annually.

Based on standard loan amortization calculations, this would mean a principal and interest payment every month of $214.69, with the loan being fully paid off at the end of 5 years.

The total cost of the loan would be $12,881.32 ($632.83 in interest paid + the principal).

This means the net cost of that 2% loan was only $5.10!

For $5.10, you get to hang on to a nice pile of cash as a backup for life’s emergencies for 5 years, and end up with a fully paid off car.

Mind = blown.

But wait. . .what happens when we crank the interest rates up a few notches?

Whereas Ed goes mad scientist on this experiment

I took the variables from the above example and put it into a table, stepping up the interest rate each time with a 1% gap between interest earned and interest paid (for a 1% investment yield, we’re financing a 2% loan, for a 2% yield, a 3% loan, and so on).

Yield on savings

$ invested

 

Total investments after 5 years

Interest on loan

Amount borrowed

Total interest paid

Total Loan after 5 years

Relative Yield (Total investments -Total Loan)

1% $12,248.49 $12,876.22 2% $12,248.49 $632.83 $12,881.32 -$5.10
2% $12,248.49 $13,535.55 3% $12,248.49 $956.87 $13,205.36 $330.19
3% $12,248.49 $14,228.06 4% $12,248.49 $1,285.99 $13,534.48 $693.58
4% $12,248.49 $15,914.86 5% $12,248.49 $1,620.16 $13,868.65 $2,046.21

We see the same $5.10 it would cost us to hang on to the principal and finance the car.

We also see a pattern.

Although the gap between savings yield and loan interest remains constant at 1%, the higher the rates go, the more it makes sense to buy the car with the bank’s money.

What does it look like if we extended the scenario over a 30-year period?

Yield on savings

$ invested

Total investments after 30 years

Interest on loan

Total amount borrowed

Total interest paid

Total loan after 30 years

Relative Yield (Total investments -Total Loan)

1% $12,248.49 $16,367.25 3% $12,248.49 $6,341.96  $18,590.45  -$2,223.21
2% $12,248.49 $21,865.71 4% $12,248.49 $8,802.94  $21,051.43  $814.29
3% $12,248.49 $29,204.32 5% $12,248.49 $11,422.43  $23,670.92  $5,533.39
4% $12,248.49 $38,996.52 6% $12,248.49 $14,188.44  $ 26,436.93  $  12,559.59

If your original sum was earning 4%, you’d make $12,559.59 over the 30-year life of the loan at 6%.

If for some reason you were able to get an investment yield at the SAME rate as your loan, you’d really be in the money.  And you still end up with a fully paid asset at the end of the loan period!  

Making the forced savings be with you

Cropped coins

The reason this works is that you are not drawing down on your principal to service the loan. If you did, the whole thing would be a wash. By keeping the principle intact, and servicing the loan with a separate income, you are building up quite a nest egg and will end up ahead.

Key takeaways

  • If you have to choose between spending $12,248.49 on a big ticket item, versus putting that money in an investment vehicle that earns you 4%, and financing at a higher rate of 6%, you are actually paying less interest with the loan.
  • The higher the interest rate, the greater your yield (even though the rate gap remains the same).
  • The longer the duration, the sweeter the deal, (only at the higher yield rates).
  • Make sure you are able to service the loan you take independent of the money you are investing.

Does this work in the real world?

In the real world, many of us already have a debt to service, so this isn’t going to help (fortunately, there are ways to cut your spending and focus on paying off the loans, like this woman did).

In the real world, there are also associated costs that come with many loans.

And there are still a couple of big elephants in the room:

  1. How does one find a SAFE investment vehicle that would return 2-3% a year?
  2. If you have credit score difficulties, how are you going to get a competitive loan? A friend of mine graduated 10 years ago and is still paying her student loan, which is at 9%. Student loans can really suck if you aren’t careful.

In the scientific world, an experiment only holds water if it can be replicated, so my geek project this summer will be to track down these elephants.  Stay tuned!  I’ll share my findings down the road.  In the meantime, if you’d like to dive into the spreadsheets I used to arrive at these conclusions, leave me a comment below.

Until next time.

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