Effect of Inflation on Bank Loans
Borrowing money from banks at zero interest rate? Milan Doshi shows you how
If you were to ask any person from our parents’ generation, the common advice they would give is:
- Don’t borrow any money
and
- If you really need to borrow, borrow as little as possible and return it back as soon as possible
Their reasoning is that having a peaceful sleep at night is extremely
important. If you were to owe anyone any money, there is this
deep-rooted fear that someone might knock on your front door in the
middle of the night demanding that they be repaid on the spot.
I am not too sure but perhaps it could partially be due to movies. In
many movies, there are scenes where the greedy landlord and his henchmen
come knocking on the poor farmer’s door demanding that they be repaid
on the spot. When the poor farmer is unable to do so, the landlord then
forcefully takes over what few possessions the farmer has and kicks the
poor farmer and his family out of the house.
There is no way we can fully appreciate what our parents might have gone
through in their generation which shaped their beliefs. Many of them
would have lived through the Second World War, the OPEC oil crisis,
racial riots, etc. In those days, being able to have 3 decent meals a
day was a luxury, something that we today take for granted.
Leveraging on bank borrowings
As a result of this misplaced fear, many of our parents have completely
missed out on the power of leverage by using bank borrowings for
property investments. In fact, I recall the day my father bought a
double-storey house in Singapore in 1973 for S$120,000 which was a big
sum in those days. He had taken a 25-year loan and one of his life’s
goal was to look forward to the day the property loan is fully settled
and the house finally becomes his. The loan was finally settled in 1998
and my father sold off the house for around S$1 million a few years
later and moved into a condominium as both my parents had trouble
climbing stairs.
Another reason why their generation didn’t like to take up big bank
loans for property purchases is that the amount that has to be repaid
back over long periods is close to double the original loan amount. They
prefer to work hard, save money for a few years and then take a small
loan to save on bank interest costs. Unfortunately, their well-meaning
advice given while we are growing up makes many people afraid to take on
big loans. Hopefully, this article changes your perspective on this
issue.
Are bank loans making you poorer?
Let’s take the example of a loan for RM1 million at a fixed interest
rate of 5% per annum for 25 years. The yearly installment works out to
RM70,952 per year or RM5,913 per month. Multiply by 25 years and the
amount works out to a staggering RM1,773,800! Imagine borrowing RM1
million but having to pay RM1.773 million back i.e. the principal amount
of RM1 million plus interest costs of RM773,800. As a result, many
people would rather avoid borrowing money and hence miss out on property
investments. Their logic would be “Why take unnecessary risks to make
the banks richer and yourself poorer”?
Unfortunately, these people are looking at things from the wrong angle.
They don’t realize that the money returned back while in absolute terms
is totalling RM1.773 million, its value after taking inflation into
account is completely different. You are not paying RM1.773 million
today, but RM70,952 per year spread over the next 25 years. The
purchasing power of RM70,952 today and its value 5, 10, 15, 20 and 25
years is vastly different.
For readers who are not mathematically-inclined, let me first explain
the effects of inflation in an easy manner. Let’s assume RM1,000 today
can buy you 1,000 lollipops. If inflation is running at 4% per annum,
the value of
1,000 lollipops
RM1,000 one year from now = -----------------------
1 + Inflation Rate
1,000 lollipops
= ------------------------
1 + 4% (or 1.04)
= 961.5 lollipops
Hence RM1,000 one year from now can only purchase 961.5 lollipops.
Therefore, the value of RM1,000 one year later is the equivalent of
RM961.5 in today’s value if inflation is 4% per annum.
Value of RM1,000 one year from now
RM1,000 two years from now = -----------------------------------------------
1 + Inflation Rate
961.5 lollipops
= -------------------------
1 + 4% (or 1.04)
1,000 lollipops
or ------------------------------------
(1 + Inflation Rate)2 or 1.042
= 924.5 lollipops
Therefore, RM1,000 two years later is only worth RM924.5 in today’s ringgit.
The formula to compute the Present Value of Future Dollars is:
Future Amount
Present Value of Amount nth years from now = ----------------------------
(1 + Inflation Rate)n
Let’s compute the Future Value of RM70,952 per year over the next 25 years assuming the inflation is 4% per annum:
Year Amount (RM) in Present Value
1 70,952 / (1 + 4%)1 = 68,223
2 70,952 / (1 + 4%)2 = 65,600
3 70,952 / (1 + 4%)3 = 63,077
Calculate until Year 25 and add up all the various Present Values gives
the answer of RM1,108,425. What this means is that while we will be
paying in absolute terms a total of RM1.773 million, the actual value
after inflation at 4% per annum is only RM1.108 million.
Suddenly borrowing money doesn’t look so scary.
In fact, it will start to make even more sense. Study the table below
for the Present Value of a loan of RM1 million for 25 years at interest
rates of 4% and 5% for various inflation rates:
Notice that if your bank interest rate is 4% (or 5%) and your inflation
rate is 4% (or 5%), the Present Value of the Total Installment paid over
25 years will be equal to your bank loan of RM1 million. The bank
interest cost and inflation cancels each other out. It’s equivalent to
borrowing money at zero interest rate!
Inflation cancels out bank interest cost
If your personal inflation rate is above the bank interest rate, you
actually end up paying less back. For example, if the bank interest rate
is 4% (which is the current rate of BLR – 1.8% for residential
properties) and your inflation is 5%, you actually end up paying back
RM902,181 for a loan of RM1 million. Unbelievable, but it’s true.
Malaysia’s official inflation rate is around 3% per annum. Unfortunately
this is not what most of us experience on an annual basis especially in
recent years. Most families’ inflation rate will hover between 5% – 10%
per annum depending on the parents’ (around 4-6% pa) and their
children’s (around 6-10% pa) lifestyles. The inflation rate for children
is usually higher than their parents due to their different consumption
pattern and spending habits. This higher inflation rate actually works
in your favor as the bank interest cost is only 4% per annum (i.e. BLR –
1.8%), far below your family’s average inflation rate.
In property investments, inflation not only works by pushing up asset
values. It also reduces your borrowing costs when inflation is taken
into account! This is another powerful reason why you must invest in
good investment properties and borrow as much as possible provided the
yields are higher than your borrowing costs. Then sit back, relax and
let inflation work its magic on both sides of your Net Worth.
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Article Contributed by Milan Doshi Financial Trainer and Best Selling Author of “How You Can Become a Multi-Millionaire Real Estate Investor!”For more information, visit www.milandoshi.com |
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