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No that's for a personal loan or any other type of loan that I can then invest.
You'd need to own a newer car outright to borrow against, or a house with a lot of equity. Alternatively if you had a massive portfolio already you might get a good rate on margin, but it would be variable, not a fixed rate.
The 88% figure would only be valid if there were no payments until the end of the loan, and then a lump sum including accrued compound interest.
Because of the amortization, it is considerably riskier than you suggest because most of the dollars borrowed are repaid over periods ranging from 1 month to 5 years.
Hopefully you now understand why I am hesitant when it comes to leverage.
But of course if you need the loan to force you to keep your consumption down, then of course go for it regardless, even if the rate is higher...
Nope. That's not how NPV works. You can use the powers of the internet if you have any interest educating yourself. It's a rudimentary concept in finance. Anyone who has had any finance/business coursework in college has covered it.
Nope. That's not how NPV works. You can use the powers of the internet if you have any interest educating yourself. It's a rudimentary concept in finance. Anyone who has had any finance/business coursework in college has covered it.
All the cash flows enter the NPV calculation at the time they occur, not at the end of the loan.
Yup. And historically S&P 500 has had an annualized return that's positive 88% of the time over said five-year period. FYI, that's the geometric return. It really doesn't matter if the S&P goes down 50% in year 1. If the five-year return is positive, it's positive. And historically it has been 88% of the time.
For a real world example, you take a loan out in January 1, 2008. The market then proceeds to drop by more than 50% over a year and a bit. Doesn't matter. The five-year annualized return is still positive. Obviously, if you're a market timer type it matters. You'd have been much better off if you waited until January 1, 2009. That's market timing crystal ball crap though.
Yup. And historically S&P 500 has had an annualized return that's positive 88% of the time over said five-year period.
Ok, let me break it down for you.
Imagine a relative offers you a $1000 loan, to be fully repaid one year from today, but no payments due before then. You take the loan and invest in an S&P 500 index fund. You then sell at year end to repay the loan.
Is the NPV positive or negative?
It should be obvious that the answer is - if the return during the year was greater than the loan interest, then NPV > 0. Otherwise not.
Are you with me so far? (#1)
Now let's say, instead, the offer is a 2-year loan instead, again no payments due until maturity. What now?
Similarly, NPV > 0 if the 2-year compounded growth rate, expressed as an annualized figure, exceeds loan interest. It's just like in the first case, except the period is 2 years, not one. Similar answer for the same reason.
Are you with me so far? (#2)
Ok, let's say you get offered both loans. Since the transactions are separate, the NPV of taking the loans and investing them together is simply NPV(1) + NPV(2). (Equation 1). In other words you simply have all the cash flows of each, put together, each discounted to present value and then they are all summed.
But there is an alternate way of viewing this. Put together, you have a single $2000 loan, with two payments due - one after 1 year and the second after another year (2 years from origination).
The NPV of this two year loan is the sum of two terms - NPV(1) and NPV(2). The first term depends on the 1-year return of your S&P 500. The second term depends on the two-year return of the S&P.
So the NPV of the $2000 loan is positive or negative depending on not only the two-year return of the S&P, but also the 1-year return, because that 1-year return appears explicitly in Equation 1.
There is of course no limit to how many payments we can add. If we have a loan with 1 payment due in 1 month, another payment due in 2 months, and another in 3 months, etc. all the way to 60 months (as the car loan example), then your NPV is a sum of 60 terms. The first term depends on the 1-month return of the S&P, the second term on the 2-month return, etc.
Thus the mere fact that the 60-month CAGR exceeds the loan rate is not sufficient for NPV > 0 for the whole loan.
When one works out the math, at 2.5%, the total interest paid is a lot less than 10k for a 20k loan, even on an 8yr loan, we see a payment of $230.08/mo, for 96 months. That comes out to a grand total of $22087.68 paid to the loan company in exchange for the $20k they paid the dealer. It is very misleading to claim that one is paying $30k for a $20k car, when the loan will be in far short of that amount of interest.
If one is financially savy, they could just borrow at that rate and use the 20k to pay down their mortgage or invest it in a way that gets them more than 2.5% after tax returns.
A couple things what they s&p is up is somewhat meaningless one because you can't directly invest in it and two investors normally don't even come close to the performance of the s&p
Secondarily the s&p just being positive isn't enough, for instance on a 20k 5 year 3% loan you will pay 1562.00 net monies after tax cost or so in interest so the s&p being up doesn't cut it.
Even better when you look here adjusted to CPI drops the positive periods to 73.5% if you remove all single digit positive periods it drops to 66% the idea of removing the single digits is that inflation is, in theory eroding the debt plus the fact that total interest over the loan doesn't add up to 3% of the original loan balance
Once you factor in how poorly the average investor performs most would be better off avoiding the taking debt to invest more idea
When one works out the math, at 2.5%, the total interest paid is a lot less than 10k for a 20k loan, even on an 8yr loan, we see a payment of $230.08/mo, for 96 months. That comes out to a grand total of $22087.68 paid to the loan company in exchange for the $20k they paid the dealer. It is very misleading to claim that one is paying $30k for a $20k car, when the loan will be in far short of that amount of interest.
If one is financially savy, they could just borrow at that rate and use the 20k to pay down their mortgage or invest it in a way that gets them more than 2.5% after tax returns.
Agreed, on both points.
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All the cash flows enter the NPV calculation at the time they occur, not at the end of the loan.
