How Do You Want to Pay For It?

Communicate how interest paid on a declining (amortized) balance compares to the interest generated in a compounding (increasing balance) scenario.

How would you like to pay for it?  We now understand the true cost of our major capital purchase and now we need to determine how we are going to pay for it.  

Let’s assume you have $30,000 in your tank earning 5% over 5 years. You will earn $8,501 in interest over that period and your account balance will be $38,501.

So if I ask you the cost to buy a car costing $30,000 over 5 years you would say? That’s right  $38,501.

What if you can finance it at the same rate of 5% over 5 years. You would pay $3,968 in interest [click on interest paid[. Including the opportunity cost the interest at interest would be $4,673. [Click on interest at interest to see the principal at interest.] We also have to factor the Principal at interest which would be $33,827. [click on the principal at interest to show the TCO or Total Cost of Ownership.]  

If the cost is the same whether you pay cash or finance it, which option gives you the greatest control and is the best decision for your current cash flow position?

[Producers Note: You may wish to illustrate the same principal with a mortgage discussion. If you pay $300,000 in cash for a house the cost over 30 years would be $1,340323 assuming a 5% interest rate.  If you finance $300,000 at the same 5% rate the cost is going to be the same. Giving up your cash and the access to it may not be your best alternative. More explanation of this concept is found in the Mortgage Master™ App in the Circle of Wealth® system.]

First, the Debtor:  They have no money, so they are forced to borrow.  What does it cost them to buy a $30,000 car at 5% interest over 5 years? Assuming normal payments of $566, at the end of 5 years, they would have paid back the $30,000 principal plus an additional $3,968 in financing costs. Is that all it cost them? No. One must also consider the opportunity cost lost on the monthly payments – since they no longer have those dollars or what they could have earned if invested. Over the 5 years, the debtor paid $3,968 in financing costs, but considering what those dollars could have earned at a 5% investment rate, the debtor really transferred away $4,673 of their wealth to financing. Is that all? Not necessarily. To see the whole picture, one must consider whether opportunity costs apply to the principal as well. In this example, the debtor purchased a $30,000 car. Let’s assume they have other cars, it’s a pure expense and we want to know the total wealth transferred away to park it in the garage. To do so, we must calculate opportunity costs on both the interest and principal repayments. In this case, the total cost of ownership for their purchase decision is $38,501.  

What does the same purchase cost the Saver? The saver must first save up $30,000 so they can “pay cash” for the car. Does the car purchase only cost them $30,000 over the next 5 years? No. One must still consider the opportunity cost of that cash payment – since they no longer have those dollars in their account earning interest. Assuming the same 5% investment rate, it turns out that the $30,000 car costs the saver $8,501 in lost interest over the 5 year period – the exact same wealth transfer experienced by the debtor! In reality, paying cash is no more efficient than financing when investment and financing rates are the same.

Paying cash means they have drained the tank and killed compounding on that amount of money. One might say “if they paid themselves back the $30,000 they spent, plus the interest they lost while the money was out of their account, their account balance would still be $38,501.”  However, this depends on their ability to put it back, not the power of compounding.  I have met a few who had the discipline to put what they took out back in to their account, but I have yet to meet anyone who put back the interest they lost while they were using their own money.  

Consider this, when you see something you want to buy for $100, then you find out you can get it at a 20% discount somewhere else, do you set aside the $20 you did not have to pay for your future? I doubt it.  

Math is one thing, and we need to understand the math, however life is not math. In theory, the Saver may have every intent to pay themselves back, but too often life gets in the way and something comes up that either postpones the dollars being replaced or eliminates the replacement altogether.

Since the only person this is hurting is them, it is easy to rationalize that they will make it up later with future earnings - which again is additional cash flow. In the end, the Saver’s strategy is putting their future at risk just like the Debtor, because to make up for the action they are taking today by draining the tank, it will require additional cash flow in the future - which they may not have the ability or discipline to replace.  

The Wealth Creator wants to make the same $30,000 car purchase. We’ve already discovered that it will be the same $38,501 wealth transfer whether they finance or pay cash, so what does the Wealth Creator do that’s different? They’ve saved and have the money so they could pay cash and drain the tank, but instead they decide to continue saving and keep their money compounding, (5% in this example), and collateralize a loan to make the purchase. By continuing to save, the starting balance of their savings or investment account will grow by $8,501 due to compounding over those 5 years (plus the ongoing additions to their savings account and the interest earned on that as well) while their lifestyle cash flow funds the their car payments.

The Wealth Creator is still obligated to pay financing costs of $3,968 over that time period. And because of opportunity costs, we know that’s really a $4,673 wealth transfer. So how do they minimize this? Since any interest paid is interest lost, the faster they pay off the amortized loan, the less interest they will pay and consequently, the less wealth they will transfer away. Paying your loan off quicker doesn't change the cost of what you bought, but it will impact your cash flow by eliminating your payment sooner.

The power of compounding is that you keep your money working for you.  You never want to reset compounding because the money you are saving and investing will one day be called upon to replace or augment your future lifestyle. I recommend that you value and protect your savings and investment dollars. You need to make sure that what you are putting away in those accounts today will provide the lifestyle you desire in the future.

It costs money to live. The money you spend on your lifestyle is for you to enjoy - you will never get it back. I like to think of it like time. You will never get back the time you have spent and it would be a shame to waste it. Like time, you can never recapture money you have wasted on foolish decisions.  Once spent, it is gone and you can’t get it back.  

That is why you should seek to be as efficient with your lifestyle money as you are with your savings and investment dollars.    

Producers Note:

The Wealth Creator is moving forward in their savings and investment accounts because they keep their money compounding without interruption while they are losing interest they are paying on their collateralized lifestyle purchase.  

It should be clear that this screen is not saying that you can make money by borrowing.  This screen is simply illustrating the related effects of interest and compounding on the purchase strategy decision.

Both the amortizing and compounding interest account schedules use a monthly mode. They are both calculated in worksheet fashion using the following basic equations:

Loan interest due = current loan balance * monthly loan rate.

Current loan balance = previous loan balance + loan interest due - monthly loan payment

Investment interest earned = current investment balance * monthly investment rate

Current investment balance = previous investment balance + investment interest earned + monthly contribution

Loan Interest at Interest (Int@Int) = previous Int@Int + (previous Int@Int * monthly investment rate) + monthly loan interest due

Loan Principal at Interest (Principal@Int) = previous Principal@Int + (previous Principal@Int * monthly investment rate) + monthly loan principal payment

Loan Total Cost of Ownership (LoanTCO) = previous LoanTCO + (previous LoanTCO * monthly investment rate) + monthly loan payment