The Loan Dilemma

The Loan Dilemma

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????????????? Let’s say that you walk into a restaurant and they offer you a deal. You can pay $50 up front for a steak or you can pay $0.24 per month for the next 30 years. You are pretty hungry, so you are definitely going to buy the steak. The question is whether you pay upfront or pay over time. You do the “quick” math in your head and realize that over the course of the next 30 years the payments will equal $86.40. Are you being scammed?

????????????? Few things in the finance community divide people more than the use of debt or leverage. Some people believe that all debt is bad debt, and you should never buy something that you can’t pay for in cash. Other people believe you should press every edge. If you can borrow for 5% and earn 6%, then they will do it. The answer lies somewhere in the middle.

????????????? Some debt is universally bad. Credit Card debt comes with very high interest rate and very low minimum payments making it very easy to spiral out of control. Due to the low minimum payment interest will accrue on the outstanding balance at rates that could be as high as 25%-30% per year. This does not apply if you pay of your balance in full every month.

????????????? Payday loans are loans designed to float people until their next paycheck. They have obscenely high interest rates and they are generally due within a month. Unfortunately, people who take one have a tendency to take another one to cover the first one leading to a similar issue with the credit cards. Spiraling debt balances because of high interest rates and the inability to make payments.

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What about mortgages? Let’s go back to our steak example.

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Scenario 1: You open your wallet, take out $50 (grumble about inflation), and pay for the steak. You are smug because you saved $36.40 by paying for the steak now instead of financing it over time.

Scenario 2: You sign the agreement to pay $0.24 per month for the next 360 months and enjoy the steak without paying anything (at the moment). You have bigger plans for that $50.

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Facts

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·?????? By paying $0.24 for 360 months ($85.93) for a $50 loan you are paying an interest rate of 4%

·?????? A 30 year U.S. Treasury Bond pays 4%

·?????? The historical rate of inflation is between 2% and 3%

·?????? You can comfortably afford to pay for the steak upfront

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Everything that you have read about this topic probably addressed whether you can earn a better return by investing the money and paying the interest. What if I told you that people are overlooking another factor that might be extremely meaningful.

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INFLATION

Financial Planners love to harp on the effect inflation can have on the success of a financial plan. They will say something like, you need $100,000 per year for your expenses adjusted for inflation (estimated at 3%). They will proceed to show a chart itemizing year by year (year 2: $103,000, year 3: $106,090, year 4: $109,272.70). Each year that goes by will cost you more money even though you are doing approximately the same thing. What if this force could be used for good?

Your steak loan has fixed payments. Each month you are going to pay $0.24, but due to inflation not all of these payments are created equal. In year one you will make payments of $2.88 with buying power of $2.88. In year two you will make payments of $2.88 with buying power of $2.79. In year 10 your payments of $2.88 will have buying power of $2.19. In year 30 your payment of $2.88 will have buying power of? $1.19. My question is…

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IF INFLATION IS SO NEGATIVE FOR OUR INVESTMENTS, IS IT EQUALLY POSITIVE FOR OUR DEBTS?

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If we look at the value of each of the payments (adjusted for inflation of 3% per year) we actually end up paying approximately $57.50 in today dollars. Would you rather pay $57.50 after 30 years or $50 today for that steak?

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Take the Loan and Invest the Cash

Here is a critical look at the other side of the coin. With any investment you have a lot of factors. We are going to focus on the rate of return, inflation, and taxes.

People are very quick to say that you should take a loan and invest your cash if your rate of return is higher for the investment than the rate of the loan. Let’s look at the other two factors.

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TAXES: Most Investments are going to have some tax consequences: Short or Long Term Capital Gains, Interest Income, Dividends, etc. We should really be looking at the After-Tax Return of investments.

The gross return of investing $50 in the 30 year treasury bond would be $60 ($2 per year * 30 year). If we use a 22% federal tax bracket, we would net $46.80.

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INFLATION: Over time your buying power is going to erode. We should be looking at the REAL RETURN (Gross Return net of inflation). The net cashflow adjusted for inflation is $31.15. We get our $50 back at the end of 30 years, but remember to adjust the $50 for inflation which brings us to $20.05. The net result is $51.20.

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Conclusion: ?NO!

1.????? Inflation is cancelled out when you are taking a loan and investing the cash. (buying power of the principal and returns is reduced and purchasing power of the payment is reduced)

2.????? There is a reason why banks allow you to pay down your mortgage early. Inflation is eating away at the buying power of the money from the loan payments they are collecting.

3.????? Most people don’t factor in the tax consequences of the investment they are making with the cash. Rate of return minus TAXES needs to be greater than the loan interest rate.

4.????? The higher the loan amount the greater the spread needs to be (in percent terms) just to breakeven.

5.????? Mortgages could be an exception, but remember due to the larger standard deduction and cap on SALT (State and Local Tax deduction) fewer people are able to deduct mortgage interest.

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