In my last blog we talked about the two most important financial percentages which guide us in making financial decisions.
This blog will discuss some practical applications and also to highlight some considerations when making those decisions.
I have received a call from my XXX bank officer offering me a 5% personal loan. Should I take it to settle my 6% personal loan? My 6% personal loan has balance 12 out of 36 months instalments.
On surface, the 5% personal loan offer should be taken, as we might recall, when we borrow money, we want to reduce our rate as much as possible. If we can reduce our personal borrowing rate from 6->5%, it is considered a reduction.
However recall too that we must annualise the interest rate, considering:
- calculation method
- frequency of charging
Personal loan interests are charged upfront and if we pay off the loan early, the interest saved is actually less than what we think it would be.
The actual rebate/interest saved can be calculated refering to:
We will find that the interest we save is closer to 4%. So now actually, 4%<5% so in fact we shouldn’t have taken the new loan to pay the old loan.
Why personal/car loans interests are calculated this way is because of historical reasons where electronic calculators have not been invented and it is difficult to calculate reducing interest rates.
Oh wow, my bitcoin/stock/property investment made 100% gain over the last 3 months, sure beats putting money in an investment with a lowly return of 8% per annum.
It happens, we made great money by luck and we think it’s the best thing ever. However recall that we need to annualise the Return on Investment (ROI) after fees and taxes. Sure we made 100% gain over 3 months, but we also
- Chicken out, took the money out into fixed deposits for the next 10 years, waiting for the next ‘buying opportunity’
- Bought some failed investments that lost money
- Paid some expensive lawyer fees, loan fees, transaction fees, stamp duty, RPGT
In fact, the usual case is that after the initial boost, the annualized ROI keeps going down every year until we come to the next market cycle. After a full cycle, we can then make an effective comparison of the annualized rate of return.
Hey I’ve got a great idea, I should take out that 5% personal loan to invest in an 8% ROI investment portfolio
Actually no, it’s the same as case study #1 above, check the annualized interest rates first (which is about 9% for a 3 year tenure). https://loanstreet.com.my/calculator/flat-to-effective-interest-calculator
Hey I got my annual bonus, I should pay down my mortgage loan instead of investing
Normally, investing will get a higher ROI than the saving we get from paying down the mortgage loan. Everybody knows that now. But in actual reality we see people talking themselves out doing this strategy with some pretty convincing story:
- I’m retiring soon and don’t want to make the monthly commitment
- Investing is uncertain, paying down mortgage is guaranteed savings
So the actual problem is that people do not understand the market, how is it possible to generate stable income from investments. I’ve discussed previously how to bring down volatility in investments and here’s a reminder from the internet.
There are many more real life cases, but if you noticed, I picked one comparing Interest Rates, one comparing ROI and one comparing Interest Rate to ROI. Some solutions are more technical, which is why financial advisors are needed and other solutions are emotional, which is why financial advisors are EVEN more needed.