Cash or Loan decision is a common everyday situation. Should someone pay cash for a TV that costs $1000, or loan which charges $50 interest for a year? It really comes down to how people value their cash. If you think paying cash is cheaper, Think Again!
The real answer is both methods are the same. $50 is the cost of capital for the duration. In other words, fair future value of $1000 a year from now is $1050. People either lose $50 potential interest by paying cash, or pay $50 loan interest. If you think there is no way you can earn 5% interest in a near Zero interest environment, just hold that thought and continue.
What is “Cost of Capital”?
Cost of Capital is the money investor could have earned by putting into a specific investment. I choose Moody’s Seasoned AAA Corporate Bond as a reference. Its current yield is at 3.32%. But I use average 5% rate of return as reference cost of capital.
What does Cost of Capital mean in our daily life? It means:
- You must earn at least 5% on capital on hand, such as Cash or Cash Equivalent, or you are losing value of your money
- You should expect to pay at least 5% interest on capital you borrow.
First step is always the hardest. It is more true when it comes to saving money. In recent study, “69% of Americans Have Less Than $1,000 in Savings”. Unfortunately even the best strategy won’t work for people who don’t save. To all determined and disciplined savers, they should put money in a place which would generate rate of return at “Cost of Capital” or higher. Their capital should never go down in value despite market conditions. Capital should be fully liquid and available immediately without access restriction or penalty.
Whenever there is a need for capital and cost/rate is higher than Cost of Capital, borrow and use your capital as collateral. You expect to pay yourself at least the “Cost of Capital” rate if not higher, while your capital continues to grow at rate of “Cost of Capital”. If there is financing option less than “Cost of Capital”, go with cheaper loan and save the different back in your own capital pool. But watch out for hidden charge or inflated price when some offers super low interest.
Now let’s see some scenarios:
- Tom wants to expand his landscaping business by adding one more truck. It would cost him $50,000 to purchase the truck with business loan at 10% from a finance company. He could borrow from his own capital and pay himself not 5% but 10% or even 12% back.
- John finds a great investment property which would cost $200,000 but generate $3,000 monthly income, 18% of return on property value. No bad, but it has to be done fast. John uses his own capital to close the deal quickly without underwriting, pay himself 12% interest from rental income.
- Alex finances his new car at 1.99% from car manufacturer since car loan rate is lower than “Cost of Capital” rate. He could choose to save additional 3% to his capital pool. A good saving habit makes the different in long term.
- Mary borrows $10,000 to pay for a medical procedure, but she can’t afford to pay back for a period of time. After all, it is her money. Her capital still grows at 5% continuously while loan rate stays at 5% as well which results a wash, because she merely pledges her capital as collateral.
Saving money is a simple concept. But it is also easy for people to save money in the wrong place, such as low risk bank savings account or high risk equity account. On top of all, earning is usually taxable immediately at marginal rate. Neither one is suit for our strategy.
To implement our strategy, we apply a high early cash value whole life policy to build up cash to target size in 2 to 7 years. Total Premium could break even with Net Surrender value as early as year 2, which is unheard of to many whole life owners. After year 7, there will no more premiums and cash value growth will take off at between 5 and 6 percent under current assumption. Cash value will never go down and gains are tax deferred and tax free to distribute. Whenever you need money, there is no hoops to jump through. Money is just a phone call away. There is no finance charge if you miss a payment. But once people understand they are owner of the capital and borrowers at the same time. They are the bankers themselves. They will pay off the loan. If they are smart, they will pay it down faster with higher rate. There are many benefits of life insurance, but they are icing on the cake when we focus on cash accumulation aspect.
If you think it is too good to be true or simply confused, Contact me and I can set up a web session to discuss.Premium vs Cash Value