Today I had an argument with an individual … a very successful individual … about how a person with discipline could actually accumulate a nice nest egg by borrowing money from one bank and depositing it into another bank.
I will not tell you who the person is that I had this discussion with … but will tell you that he could not believe what I was saying was true – even though he has allowed me to help him manage his money in the past. His words, “How in the heck can someone make money if he is paying one person or entity a higher rate of interest than he is earning? Impossible!”
Well, let me explain it to you.
Let’s make the Impossible, Possible …
Go to Banker A and borrow let’s say $10,000. Tell the banker you’d like to pay this back over the next 3 years (36 months) at whatever is required. Let’s assume the bank is willing to make you this loan for a period of 36 months at an interest rate of say 7% per year (compounded monthly). This means your monthly Principal and Interest (P&I) payment will be $308.77.
Therefore, over 36 months you will pay the banker $11,115.75 in Principal ($10,000) and Interest ($1,115.75).
Now what would happen if you took that same $10,000 and went to purchase an annuity or CD that would provide a return of say 5% per year (Yes, you may not get that in a CD this year but you could in an annuity). However, it appears that this would not be a good deal because you are only earning roughly 71.4% of what you are paying in interest (5% divided by 7%) – how could you earn any money?
Well if you invested $10,000 at 5% per year (compounded monthly) this is what you would see happen in the next 3 years (or 36 months):
The interest (column 2) is simply 5% divided by 12 months and the product is multiplied by the 1st column then added to the 1st column to equal the 3rd column.
So, while you paid one banker 7% or $1,115.75 to borrow the money … another banker, insurance company or investment firm paid you 5% or $1,614.62 to save the money borrowed. Therefore you, in fact, made $498.87 in interest over and above what you paid.
Why and how is this even possible?
Because the interest you are paying on the loan is the interest on the unpaid balance each and every month while the interest you are earning on the loan is the interest on the compounded balance each month (so interest on top of interest). That is the power of Compounding Interest that few people care to understand, and many of our schools fail to teach.
Now it is very true that if you did not originally borrow the money and simply saved or invested the payment $308.77 per month every month for 36 months and earned the same 5% you would end up with $11,965.87 at the end of 3 years – which is $351.15 more than using the loan scheme. But let me ask you this … and think about it before answering … WHAT ARE THE CHANCES YOU WILL ACTUALLY SAVE $308.77 EVERY MONTH FOR 36 MONTHS AS COMPARED TO THE CHANCES THAT YOU WILL PAY A BILL IN THE AMOUNT OF $308.77 PER MONTH FOR 36 MONTHS … Especially if the $308.77 is not on payroll deduction so that it is “out of sight out of mind?”
It is generally a lot easier for us Americans to Pay a Bill than it is for us to Save Money. If it weren’t we would stop paying bills first and saving last and change it to “Paying Ourselves First” (savings and investments) and taking care of the bills last.
Do I recommend that everyone borrow money and invest it elsewhere to help them accumulate money? No! But I have suggested it to a few in the past so that they could get in the habit of “paying themselves first” and it worked well for some and didn’t work for others.
The point of this article, however, was to prove that contrary to Dave Ramsey and others who teach against debt … loans, if used properly (and not abused), can help you accumulate wealth. Do I have any debt now … No (unless you want to consider the IRS). Have I borrowed before … Yes. Is it possible to Borrow your way out of debt? Yes if done right and the borrowings go for investment and No if done improperly and the borrowings go for spending on more junk.
Always remember: If you are borrowing to buy or invest in something that has the potential to appreciate in value at a greater amount than the interest costs on the loan … get all you can of the other mans money (the banker). However, if you are borrowing for something that you know will depreciate 25% or more when you drive it off the lot or take it out of the store (a car or other consumer items) … always use your money (and learn to do without if you have no money to use).
It never ceases to amaze me of all the people who THINK they NEED a new car every 2 to 3 years when in reality they only WANT a new car. If you borrow to purchase your first car … drive it till it’s paid for then another five years to allow you to accumulate the cash to purchase another one. Believe me when I tell you that you can get 300,000 to 500,000 miles on a car today … and when you pay cash for one rather than borrowing for one you will – in fact – get more mileage and take better care of it.
Have a great day and go make some financial waves.
Jerry Nix, FreeWaveMaker, LLC