You probably have heard of the phrase "buy term and invest the rest". It means to buy a term insurance instead of a whole life insurance and use the savings in insurance premiums for investment. Can this advice be applied to loans as well? Meaning, instead of paying off your loan over a short period of time, you stretch your loan over a longer period and use the reduction in loan repayments for investment.
Let us consider the following scenarios:
|Loan Interest Rate||2.60%|
|Loan Tenure (Short)||15 years|
|Loan Tenure (Long)||30 years|
|Yearly payment (Short)||
|Yearly payment (Long)||
|Yearly Available Sum||
|Yearly Rate of Return||7.00%|
The loan principal is $400,000. You have a sum of $32,545 yearly which can be used to either service the loan or invest in a portfolio of stocks and bonds. The loan interest rate is 2.6% while a balanced portfolio of 50% stocks and 50% bonds can return 7.0% each year on average. You can choose a short loan tenure of 15 years, in which you will pay off the loan in 15 years, after which you can channel all the money to investment for the next 15 years. Alternatively, you can choose a long loan tenure of 30 years, in which you channel $19,367 to service the loan and the remaining $13,178 to investment every year for 30 years. Which option would be better for you? The figure below shows the loan and investment amount for the 2 options.
|Loan & Investment Amount for 2 Loan Tenures|
As discussed earlier, the shorter loan gets paid off earlier by Year 15, whereas the longer loan is only paid off after Year 30. However, the investment amount only grows to $818,000 at Year 30 for the shorter loan option, compared to $1.24 million for the longer loan option. In terms of the total loan interest payable, the shorter loan incurs a smaller interest of $88,000 whereas the longer loan incurs a larger interest of $181,000, which is nearly $100,000 more than the shorter loan. This means that there is nearly $100,000 less available for investment. Yet, due to the longer period of compounding, the longer loan option is able to generate $849,000 in investment gains, as compared to $330,000 for the shorter loan option. This example shows that the time period available for the investment to compound can be more important than the amount of money available for investment.
From another perspective, the servicing of loan can be considered a form of investment. The "return" from this "investment" is the loan interest rate, which at 2.6% is lower than the 7.0% return available from the balanced portfolio of stocks and bonds. Hence, it is more beneficial to channel most of the money to the investment with higher returns, which is the balanced portfolio. Conversely, if the rate of return from the balanced portfolio is lower than the loan interest rate, then it is better to channel most of the money to pay off the loan as soon as possible. In essence, loans and investments are 2 sides of the same coin and should be assessed in the same manner.