Thursday 14th December 2017
”If it sounds too good to be true, it probably is.”
Gearing is the word that describes the relationship between what you owe and what you own.
Being a little more technical , ‘gearing’ describes your debt level versus the value of the asset for which you are in debt.
Negative gearing means that your asset is worth less than you’ve borrowed (net liability) and is popular in countries where governments allow tax deductions for such investments. Positive gearing means that your asset is worth more than you owe (net asset) and is what helps protect you against unforeseen problems where you may have to sell an asset quickly to stay afloat.
If you try to pay out a loan too early, you may find out that the balance due is more than the amount you initially borrowed. In fact, there was a time (before warranties improved) when you could easily get yourself into a situation where the warranty on your new car ran out while the finance payout was more than the original purchase price of the car. It’s still common that the current value of a near-new car is less than you owe.
The same applies to people who ‘over-gear’ their investments – with their geared investments normally being real estate or shares.
Over-gearing means that you are in trouble because you owe too much compared to your assets. A good example of the way over-gearing starts is when you buy real estate in a rising market. Because values keep rising, rents you receive also keep rising. People are unable to buy at higher prices and so are forced to continue renting, therefore increasing rental demand and driving up rental prices.
So you keep investing in more real estate, based on your ever-improving equity (difference between what you owe and what you’re ‘worth’). Then, as developers flood the market with new properties for sale, tenants start buying their own homes because the increased supply of properties for sale has driven down purchase prices. The tenants, who are paying huge rents, would be stupid not to seriously consider buying.
Guess what? Like a gambler who keeps gambling because they are hooked after one big win, you’re over-geared and have an income (cash flow) problem!
Even worse, if you don’t keep increasing your property insurances to keep up with their rising values, you may find yourself in big trouble after a fire or some other unforeseen disaster.
The same situation can happen with shares. Share prices can be volatile, so increasing borrowings against a portfolio (particularly one that has only one or two stocks) that is rising in value can quickly backfire if the stockmarket suffers a big fall.
How would you like to be over-geared on shares in a company whose own investments are over-geared?
The bottom line is that many people believe that real estate values and share prices must always go up, and most of the time that’s true. Where people get caught is that real estate values and share prices can also go down and when they do, interest rates usually go up (to stop more people being hurt, just as you might be if you don’t leave yourself breathing room).
Thursday 14th December 2017
Interest Rates vs. Repayment Amounts
“If you think nobody cares if you're alive, try missing a couple of car payments.”
It has constantly surprised me, over the decades since I was first taught how finance works, how easy it is to separate people from far more money than need be. In fact, many borrowers seem to think that financiers are the economic equivalent of fairy godmothers.
I assume that this belief is based on the sheer excitement of ‘purchases’ (based on ‘easy’ repayments) that allows people to be vulnerable in the area of borrowing.
Let’s look at an example of how you can be caught paying far more than you think you are.
Assume that you are buying a new boat and you have signed up for delivery subject to getting the finance organized. You are an astute person, so you know that different rates are available and you shop for the best rate. Finally, after an exhaustive search, you settle on the financier of your choice and take delivery of your new boat, feeling very proud of yourself.
A few weeks later, you meet someone who has also bought a boat and at the same price and interest rate as you, but is paying less than you! You are confused and a little uncomfortable because this person seemed very honest and genuine, so you call your banker/ broker/agent who assures you that you have the correct interest rate.
The difference in payment is due to the ‘front-end loadings’ on the amount you have borrowed (the initial amount borrowed is known as ‘the principal’). If you borrow the money via someone who is paid an introduction or ‘sign-up’ fee, that person will get a fee known as a ‘trailer’ (which is a percentage of every payment you make) and may also be paid a ‘front-end load’ (i.e. an upfront sum that is added to your principal and on which you pay interest for the life of the loan).
Or, you may deal directly with a financier that simply loads their fee into the loan in exactly the same way – quite common, by the way, as borrowers like the idea of only having to make an ‘easy’ regular payment rather than lump sum cash upfront and then regular payments as well.
Of course, governments want a slice of the action, too. There may be government duties, taxes and/or fees that also need to be loaded on to both the principal AND the finance agreement itself – meaning that you aren’t just paying the government’s charges, you’re paying interest on the government’s charges, as well.
Then, the lender usually wants you to pay their wages and rent as well and this cost is known as account fees, all of which may attract interest.
The reason that all of these fees are ‘front-end loaded’ is that if they were loaded at the end of the loan, you wouldn’t have to pay interest on them and lenders want you to pay them interest as well as their fees.
But it’s not just ‘simple’ interest – banks and other lenders thrive on the magic of ‘compounding’. This is where you pay interest on the interest that you are already paying on the fees, charges and the principal (which is the only thing many people think they are paying interest on in the first place).
Something else that a lot of people don’t understand is that the money they actually borrowed (the principal) gets paid off last and the lender’s and other fees and charges get paid off first. This is why, if you try to pay off a loan too early, you’ll owe more than you borrowed.
In fact, it’s common that the current value of your new pride and joy (e.g. car, boat, TV, updated kitchen, bathroom, lounge suite) is less than you owe.
The key thing is to always work out how much repayment money you can afford and leave yourself room to move in case something goes wrong.
So what’s the best process to use?
Personally, I prefer to use intermediaries when borrowing money because they will usually get a better repayment rate for me than I can, as, being specialists, they have the contacts and the market knowledge.
However, because I understand the process, although I am happy for the intermediary to make a profit, I always insist on comparing how much money is coming out of my pocket with each payment compared with the alternatives.
From now on, you’ll be the same, because you also know that the interest rate is completely irrelevant; it’s how much money you are paying out of your own income that is the real issue. I’ll repeat that: the interest rate is completely irrelevant; it’s how much money you are paying out of your own income that is the real issue.
And, just in case you forget, make sure you also compare how much you have to pay at the start of the loan (usually called the deposit or the first payment) and end of the loan (usually called the residual or the final payment). I’ll repeat that as well – you need to ask about four different types of special payments: the deposit (which is before your payments begin), the first payment (which can be a big one if there’s no deposit), the final payment (which could be a big one if there’s no residual) and the residual (the amount you pay after your final payment has been made).
In most cases, the quicker you pay a loan off, the less interest you’ll pay. However, penalties will almost certainly apply if you pay the loan out early, because they’ve lent you the money in good faith, expecting the return stated in the loan documents.
The last thing you need to remember is that, as with any contract, if you have even the tiniest doubt about the contents, ask your accountant and/or lawyer to examine the agreement and explain your obligations before you sign up.