Interest You Earn Is Weightier Than Interest You Save

Over $5,700 per household, that’s the new average for credit card debt in this country.  And the average rate of interest being charged for that credit card debt is now 17.14%!  But credit card debt doesn’t even cast a shadow compared to student loan debt.  Debt incurred for an education has now surmounted to $1.5 trillion!  With over 44 million having borrowed an average of $37,000 for college.  Interest rates on student loans vary on average from 4.5% for undergraduate studies to over 7% for PLUS loan.

If you are part of these very dismal credit scenarios, you may be feeling overwhelmed…and rightfully so.  If you are making minimum payments on your $37,000 student loan debt at 4.5%, in 20 years you will have paid $56,888.  And if you own $5,700 of the national average credit card debt and are making minimum payments with that 17.14%, you’ll end up paying $20,402 over the next 20 years.

That is why so many are quick to tell you to make more than minimal payments. They want to help you get out of debt faster, so you can avoid the dismal feelings associated with that heavy burden.  But this may not be the best advice for you to follow if you really want to end up with more than merely paying your debt off. The reason for this is because paying off your debt, while it sounds really nice and comfy, doesn’t provide you with anything else.  And that means you have nothing else.

To understand this, you must think. Because…

  • Interest you earn is weightier than interest you save!
  1. If you are paying 4.5% on a 20-year student loan of $37,000, your annual payment will be $2,844 and your total loan repayments will be $56,888.
  2. To pay it off early, say in 10 years, you will have to come up with $1,832 more annually, to make that happen.
  3. If that $1,832 each year can earn, say 3.5%, then over that same 10-year period, it would have grown to be $21,492
  4. By the time you pay off your student loan at 4.5% in 20 years that $21,492 earning 3.5% will have grown to become $30,317.
  5. Now you have something besides merely having no debt because you saved and earned 3.5% on the $1,832 of extra payments, instead of paying it to the lender.

Here is why that can happen.  The Time Value of Money!

Money, over time, can lose its value or you can make it increase in value depending on how you use it, store it and manage it.  One way to allow money to increase in value over time is to allow interest to compound in your favor by stop trying to pay extra on your debt(s) merely to eliminate your debt(s) faster.  Once you realize that saving any extra money you would pay to your creditors can create wealth for you, you will understand why the wealthy always leverage other people’s money, so they can create wealth for themselves.

This is a great lesson to learn, concerning the time value of money:  Borrowing money at a higher rate of interest than what you can earn on that money can become profitable if you follow the rules.

  1. If you can use someone else’s $100,000 and earn 3% annually over 20 years, it will grow to become $180,611.12.
  2. If you pay 4% annually on the $100,000 you borrowed, over the next 20 years you will only have paid $147,163.50 back to the lender.
  3. Your profit becomes the difference between these two figures, $180,611.12 – $147,163.50 or $33,447.62.

But be cautious, the less time you allow for compounding interest to work for you, the lower your earnings will be.  If you borrow $100,000 at 4% and pay it back in 5 years.

  1. You will pay $112,313.56
  2. While your account compounding at 3% will only grow to be $115,927.41
  3. And your profits will be reduced to $3,63.85.

And if you only allow 2 years for the compounding interest to work in your favor then;

  1. Your account earning 3% will only grow to be $106,090.00
  2. While you will end up paying $106,039.22 back to whoever you borrowed the $100,000 from.
  3. Now your profits are a mere $50.58.

The lesson to learn here is:

  • Allow enough time for money to work for you, or your profits will be reduced.

You may have heard that borrowing from the insurance company against your participating whole life insurance (PWLI) cash values is a good thing to do to grow wealth.  To see if that is true or not, you need to apply the rules learned above.

If the insurance company is charging you 5%, and you can earn 4% on the money they loan to you, you can see that from the examples above that this could be profitable for you but only if you allow the time value of money to work long enough for you to benefit.

Leveraging your PWLI cash values becomes even more valuable when the interest that the insurance company is charging you for your loan is a tax deduction.  This occurs when you use the money lent to you for an IRS approved business expense or an investment.  If you use the money for a personal expense or consumer debt, there is no tax deduction on the interest paid to the insurance company.  But it could still be a valuable consideration for you if you use the time value of money and determine the time it will take for you to recover the cost of the interest on your loan.

What doesn’t make sense is to compare the interest rate that the insurance company is charging you for a PWLI loan and the dividend rate the insurance company declares annually for all PWLI policyholders to share in.  Here is why this is not a valid comparison.

  • Dividends are not paid into your account at the rate they are declared by the insurance company.

When an insurance company declares a dividend, they do so based on their profits. The profits are above and beyond what it took them to operate the company that year, including mortality costs.  These profits are announced to the public using a percentage such at 5% or 8%.  Many insurance agents like to use this percentage figure as an interest rate that policy owners will earn rather than explain that this percentage is what the insurance company earned.  And that is a fallacy that you must overlook if you want to become profitable borrowing money against your PWLI policy.

If the insurance company charges you 5% for a loan and declares a dividend of 8% this year, but your policy cash values only grow by 1% or less, as all policies do when they first get started, you will end up on the short end of the stick if you have borrowed money against your PWLI policy expecting the dividends to cover the interest the insurance company charges you.  And needless to say, you can give it all the time in the world and never make a profit if the actual internal rate of return in your policy is less than the interest rate charged for a loan against your policy.

That means the only safe way to borrow money against your PWLI policy is to know that you can generate more money with that capital than if you left your PWLI policy unleveraged.  Always compare the difference between the interest you pay for a loan against what you can earn with that capital, if you want to earn a profit.  PWLI is not a magic wand or genie that can make money appear simply because you borrow against it.

The time value of money is a valuable factor when it is understood and used correctly.  As mentioned earlier, the interest you earn always carries more weight than the interest you save.  But you must follow the rules and allow time to work for you, or you can get burned.

The way that credit card companies, student loan lenders and financial institutions make their money is by leveraging other people’s money and allowing the time value of that money to compound in their favor.  You can do the same as they do and generate a lot of wealth that you get to keep and manage.  Or you can continue to pay others the interest they demand.  But if you choose to allow others to manage you, your time and your money, don’t blame them for getting wealthier. All they are doing is using the same tool that you can use, the time value of money, to keep more of the money you make.  All you have to do is understand the rules and put them into practice for yourself.