Posts Tagged "interest rate"
Leverage Part 1: What is Leverage?
Leverage: Think of it as using “other people’s money” to make money more quickly. Probably another topic that is best explained with an example.
Greg has $1,000 a year to invest for 10 years. Assuming a rate of return of 10%, at the end of 10 years he will have $17,531.
BUT, we know from the post on the magic of compound growth that TIME has a large effect on growth. The philosophy is that if you could instead take all that $10,000 over 10 years and just put it in now, you will have more money than by putting it in over 10 years.
Okay, let’s look at a simple use of leverage: Greg only has $1,000/year, so he can afford a loan payment of $83.33/month (That’s $1,000 per year). First we have to figure out how much of a loan he can get. Assuming a 6% interest rate, $83.33/month for 120 months (10 years) will allow him to borrow $7,530.89. So he isn’t starting with $10,000 since we have to compare apples to apples (in the form of how much cash flow he is willing to dedicate to his investment savings).
Okay, so now let’s calculate how much $7,530.89 will grow to if invested and assuming the same 10% rate of return… My trusty financial calculator tells me $19,533. So in this case he has roughly $2,000 MORE through the leverage than with the yearly savings (which yielded him $17,531).
Now before you go out and get a loan to invest, remember that a lot of people get burned on leverages – as they magnify RISK as well as return. In Part II of “Leverage” I’m going to look at a negative scenario.
You know, the topic of leveraging is a big one – I envision that I could easily write a 10 part series of posts on it, and probably will. It’s glamorous, but please make sure to consult with a professional before getting one! This post is in no way meant to be taken as advice to get an investment loan.
Having said that, if you own a house and have a mortgage – you already have a leveraged investment! :) You have borrowed money to buy an appreciating asset.
What is a GIC?
GIC: Guaranteed Investment Certificate. In the US these are known as CD’s (Certificate of Deposit). This is pretty much as safe as you can get when it comes to investing. You buy a GIC at an advertised rate (say 4% as an example) and you earn 4% per year for the duration of the term.
They are guaranteed in that it doesn’t matter what happens to the stock markets, or with interest rates after you buy the GIC, if you bought a 4% GIC, you get 4% annualized for the duration of the term you chose. (Term is just a fancy word for how long you want to hold this investment.) The only way you could lose out is if the bank went under – even then, your money is insured up to $100,000 through the CDIC (Canadian Deposit Insurance Corporation) in the event of insolvency of the issuer (aka the bank goes under). So, it’s as safe as your savings account and pays more interest in other words.
These days, there are about 100 different types of GIC’s to buy! They vary on a few features, one of which is TIME. You can buy a 30 day GIC, a 60 day GIC … a 5 year GIC, etc. Note that the longer the term, the higher the interest rate they will pay. The bank is willing to pay a premium if you promise to give them your money for a longer period of time. Note that unless you have a cashable GIC you can’t get out of the GIC (and if you can there are penalties you have to pay).
They also vary on whether they are “Cashable” or “Non-Cashable” – as alluded to above. Again, the bank will pay a premium (in the form of a higher rate of interest to you) for selecting the “Non-Cashable” feature since it means they are more likely to have your money for a longer period of time than with a cashable GIC.
These are the basic differences, but I will post on some other types of GIC’s, as well as when they make good investments and the pro’s and con’s, etc. in other posts.
What is a "Line of Credit"?
A Line of Credit is basically like a credit card in that you apply to have the ability to borrow money whenever you want and have a set limit that you are authorized to use (let’s use $10,000 as an example). The Line of Credit remains open even when your balance is $0 – and you have no payments to make. If you were to use $5,000 then you would start to be charged interest. You could pay back the $5,000 right away or you could pay it back over time, the only thing you have to make certain is that you pay the interest monthly. So if your line of credit had a 10% interest rate you would owe a minimum of ($5,000 x 10% / 12) = $41.67 per month. You could take until eternity to pay it off in full if you wanted to so long as you made the interest payments.
The interest rate on the line of credit is usually very good. It is usually at the prime rate (the interest rate offered to the bank’s best customers) if it is secured, or “prime plus 1″ or “prime plus 2″ if it is unsecured. The “plus” amount varies depending on how credit-worthy the bank thinks you are.
Refinancing your home
I’m going to offer up an example in a following post, but this post is to deal with the psychological aspect of refinancing your home to consolidate debt.
First, let’s just make sure we’re on the same page and define “refinancing your home”. This is basically when you have some equity built up in your house (after paying your mortgage payment for a few years or having put a large down payment on it) and you use that equity to pay off OTHER debts so that instead of having a mortgage payment, a credit card payment, a line of credit payment, a vehicle payment, etc you will only have one slightly larger mortgage payment and that’s it. I say slightly because you have taken all the other debt payments and in effect turned them into debts with longer repayment time lines, thereby reducing how much you pay monthly. So why do people want to do this? Cash flow – plain and simple. People can free up $1000/month in some cases which can be used for building up an emergency reserve, long term savings, and in many cases allows them to just breathe easier. (Refer to my upcoming post using a real life example with hard numbers.)
When you refinance you will generally reduce the overall amount of interest you are being charged on all of your debts as well. For example some credit cards are charging 19.9% per year, and department store cards are sometimes charging 28.8%. Once you refinance that debt into your mortgage you get a lower interest rate since the debt is now SECURED (by your home) as opposed to UNSECURED. Secured means that you basically agree that if you can’t pay your debts, the bank will get the value by selling your home, taking what you owe them and leaving you with the rest. Since the bank has a better chance of getting their value back when you secure your debt, they will lower the interest rate to reflect their reduced risk.
So the equity in the house is the total value of the house MINUS your mortgage balance. Example: you bought a $200,000 home and put $50,000 as a down payment. That would leave you with a $150,000 mortgage. Your equity would be $50,000. After a few years, you’ve paid some principal and interest back in the form of your mortgage payments and now maybe the mortgage balance is $135,000. PLUS maybe the value of the house has gone up to $235,000. At this point the value of the house ($235,000) minus the mortgage balance ($135,000) leaves you with $100,000 of equity.
One reason refinancing has become so popular is that housing prices have really appreciated, in fact we are in the longest housing bull market in history. This has created a lot of equity, and to refinance to clear up debt and reduce the overall cost of borrowing is a sound strategy (until you look at the psychological aspect of it.)
People are doing this en masse these days as people are perpetually spending more than they earn. Why do people put so many purchases on credit? Well, these days one of the main reasons have been the incredibly low interest rates – it makes the carrying cost seem very reasonable – and people became used to using credit, hence: they have a lot of debt!
So the only real problem of refinancing your home to consolidate debt? If you don’t correct the spending habits that created the situation in the first place you will start spending your new found cash flow similarly to before and end up even further behind within a few years. I’ve seen it happen and the next step will be bankruptcy! So make sure you can adjust your habits. Use a financial advisor, set up a forced savings plan with the new money and stick to it!
Your savings account choices could save you $100,000 over your working life!
Let’s take a look at how a relatively simple decision can make such a huge impact. Many traditional banks charge monthly account fees. My personal account with my previous bank charged $11/month and it paid 2% in interest.
Some “virtual banks” like ING and President’s Choice Financial have savings accounts that have no monthly fees. They typically pay a higher interest rate as well, for this example let’s call it 4%.
Let’s examine what the real cost is:
$11/month x 12 months = $132/year
But let’s take is a step further. Many banks offer a lower-fee or fee-free account to students or kids until they turn 18 – so let’s assume that we have this $11 monthly account fee from age 18 to age 65 (again, many banks have a reduced monthly fee for seniors).
Let us also assume that we are wise and decide to invest this saved money into an investment portfolio that averages 8% per year.
$132/year @ 8% rate of return x 47 years = $59,783 that could’ve been in my pocket!
So if you have a savings account at a bank that charges a monthly fee, you can see that even a few dollars a month makes a big difference. If anyone would like to step up to the plate and provide their monthly account fee and age, I will calculate your “money lost” and post it here as well. (Warning: it’s depressing!)
Note: we haven’t looked at how much less interest you earned inside your savings account during that time! Since the average, free high-interest savings account pays roughly 2% more than a traditional bank, and assuming that the savings account holds an average balance of $5000, then you are foregoing an additional $100 year in interest paid to you.
I guess I’m feeling sadistic, so let’s look at the new final total:
($132/year (account fee) + $100/year (lost interest)) @ 8% x 47 years = $105,073.
So, about 15 minutes to setup your new account today could save you over $100,000. What are you waiting for?
Disclaimer!: Most people will not invest the savings because it is not an established habit – in which case your savings will be a *paltry* $10,904 over 47 years. That is the magic of compound interest – which I will cover in another post!
I hope this post helped you out! :)
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