Most people think they know the difference between compounding and amortizing interest. The reality is generally different once you take a close look. Additionally, once you know the difference do you know how to take advantage of the difference? I will explain this by using a story and at the same time furthering our journey to find the perfect investment. (http://financialfreedomrestored.blogspot.com/2013/10/12-characteristics-of-ideal-investment.html) Let????????s discuss question 10 about collateral. Would the following be something you would want to do using a savings account? Does your savings account have this feature?
Let us assume that you have worked hard and accumulated $50,000. You see a special at a corner bank for five year Certificates of Deposits. The interest rate is 5%. You quickly park and go into the bank to set up an account with them. You are feeling good that your money is safe and will grow at a competitive rate of return.
The following weekend you go on a short out of town trip with your family. Upon your return you notice some water damage to the basement. Your heart sinks when you hear the cost of repairs is going to be right at $50,000. To add insult to injury you hear from your insurance agent that you homeowner????????s policy will not cover the loss.
Your breathing eases slightly when you remember that you own a $50,000 CD down at the corner bank. Instantly you think to yourself, I can just cash that CD in and get the basement fixed. (Did you notice that the thought process was an either/or mentality? You can have the CD or get the basement fixed.)
Upon arriving at the corner bank you announce that you want to cash in you 5 day old CD. The teller explains that there will be a $1800 dollar charge for fees and penalties. This does not sit well with you so you demand to see the branch president. As you come into my office I can see that you are upset. You go through the whole story and tell me the awful things that have happened and how I should care about you and your plight. To your surprise, I seem to really pay attention.
When you finish your story I ask you to close the door to my office. In a lowered voice I begin telling you that I cannot do much about the fees and penalties. However, I can share with you a simple concept that very few people understand, i.e. the difference between compounding and amortizing interes. The first thing I explain that you should not have the either/or mentality. You should be trying to figure out a way that you can keep the CD going and get your basement fixed, avoiding the $1800 in fees and penalties. I propose to you that you take a non-recourse loan from my bank for $50,000 using the CD as collateral. The only thing that can happen if you default on the loan is that the bank will keep your $50,000 CD. In other words, we????????ll take your CD as collateral.
You agree that is a good idea and we draw up loan documents. I explain that it is fair for the bank to charge you 5% on your loan (amortizing) since the bank if paying you 5% on your CD (compounding). You think about it a minute and agree since the interest rates are exactly the same, the deal will be equal for both sides. I also propose to make the loan duration 5 years just like the CD. I get a cashier check made up while you review and sign the documents. After everything is complete you head for home thinking I am the kindest banker you have ever met.
Then reality sets in, especially when you explain to your significant other what you have done. You realize that what you have done is borrow money. Money that must be paid back with interest (amortizing). In fact, after looking at the loan documents that plainly state the monthly payment will be $944 a month for 60 months. Doing the math (944 x 60 = 56,640) you realize that you will be paying the bank $6,640 in interest (amortizing) over the five years of the loan. Grumbling to yourself you say I can either bite the bullet now and pay the $1800 in fees and penalties or I can do as the rotten banker has convinced me an pay $6,640 in interest over 5 years.
??????A secret? You are going to share with me a secret that few know about??????? you yell as you enter my office. ??????Or do you mean very few are stupid enough to do???????
Smiling, I calmly say, ??????I figured you would be back. You want to know what is the big deal about paying the $6,640 in interest to the bank? Why don????????t you just pay the $1800 in fees and penalties and be done with this mess??????? Then I add, ??????But, you must remember the CD. You have a $50,000 CD for those 5 years compounding at 5%.??????
??????Oh yeah so the bank is going to pay me $6,640 in interest while I pay the bank $6,640 in interest. We did talk about that being a wash. What I pay you, you pay me. Maybe this is not such a bad deal after all.??????
I wanted you to go through this thought process so you can better grasp what you are learning. The truth about this situation is that you are going to make money. Make money? Yes. Your CD when it matures in 5 years will be worth $64,168. While you are making interest (amortizing) payments to the bank of $6,640 over the next 5 years, the bank will be paying you $14,168 in interest (compounding).
??????Wow, that is amazing,?????? you exclaim. ??????I thought the bank would be paying me the same I would be paying the bank. Is this for real???????
It is not only real, it is possible to do.
Can this be a reality with the type of account you have? I can help you learn how do take advantage of this little understood difference between compounding and amortizing interest. Hopefully this story will cause you to think seriously about some of the questions on our list. (The ideal investment: http://financialfreedomrestored.blogspot.com/2013/10/12-characteristics-of-ideal-investment.html) More importantly, I hope it will cause you to ask some additional ones about your plan for wealth creation.