How to use a loan as an Investment Tool

One of the best ways to trim money from your spending is to find simple little substitutes for your regular expenses.  

• That said, you can be clever with the interest payments. If you put an extra Sh10,000 a month towards your principal, the total amount in interest you will pay drops to Sh6.8 million (and you make savings of about Sh7 million) and instead of taking 20 years to clear your loan, it now takes only 11 years. This week the Centonomy class has been covering the very important topic of debt. Have you been servicing monthly repayments on your loan for a while, then found out that the outstanding balance has not reduced as significantly as you thought it would? Well, there is a reason for that.

Many people do not understand how a loan works. And, as some in our class confessed, had they understood how it works, they probably would not have taken that loan. Today, let us examine how a loan works so that you never have to utter those words.

Let us start right at the bottom, with the basics. There are two components to every loan: Principal and interest. The principal is the amount that you borrow. And when you give back the money you owe, you will pay a little more on top to compensate the person you borrowed from. This is what is called “interest”.Let us look at an example of how that works. Say you borrow Sh100,000 from your brother. At the end of the year, you agree to give him Sh110,000. Sh100,000 is the principal. The extra Sh10,000 is the interest, and you have to pay it because there is an opportunity cost to him for giving you this money.

Had you not borrowed the money, he could have invested it somewhere else, right? But you already knew this, did you not? Well, let me teach you a different way to look at that loan — a way that will for ever change the way you borrow money.The extra Sh10,000 is the actual cost of the money you borrow. The financially literate borrower will usually consider this amount before they take the loan. Most financially illiterate people, though, only consider if they can afford the monthly repayments that the loan will entail.

Let us look at how that impacts actual numbers. Say you took a car loan for Sh1 million, payable in five years. And let us say your bank will charge you interest of 18 per cent, per annum. This means that every month, you will need to pay back Sh25,393, which seems relatively affordable. However, in five years, the total amount of interest you will have paid is Sh523, 605. You have, in essence, purchased your car for Sh1.5 million. Meanwhile, your car’s value will have depreciated to Sh500,000 over the course of the five years. This is what is referred to as “bad debt” because you have lost money on it.

Your aim should be to either minimise the use of this kind of debt or get out of it as fast as possible. Now let us explore ways in which you can turn a loan into good debt. Let us say that you borrow that Sh1 million and buy a piece of land with it. The payback terms are the same, but at the end of the repayment period, your piece of land will be worth more than Sh1.5 million. You could sell the land and have your money back in your pocket — and some extra cash as well.

Let us say you buy a property for Sh5 million and take out a 20-year mortgage, at 18 per cent interest per annum. The monthly repayment will be Sh77,000 per month. In the early years of the mortgage, only about Sh2,000 to Sh3,000 per month is going towards reducing your principal. The huge balance goes towards interest (i.e. the bank’s profit). That is why you can pay your mortgage for long only to find that the outstanding balance is still high. The total interest you will pay at the end of this period is Sh13 million, which means that in total, you will pay Sh18 million for the apartment. However, it is quite possible that in 20 years, the apartment will be worth more than that.

Pertinent questions

That said, you can be clever with the interest payments. If you put an extra Sh10,000 a month towards your principal, the total amount in interest you will pay drops to Sh6.8 million (and you make savings of about Sh7 million) and instead of taking 20 years to clear your loan, it now takes only 11 years. So you spend an extra Sh10,000 a month to save time as well as money. You can use this same method for all debt including the car loan we talked about earlier.

Before you take that loan, ask yourself if you can afford the interest. Would you be better off saving money to buy the item you want? Or investing the money you have and growing it so that you can afford the item you want? Do not let the desire for instant gratification cloud your judgment. Write to us and tell us about your experience with debt.