Understanding the Time Value of Money – Episode 253

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[00:03] Welcome to the Prosperity Podcast, fresh alternative personal finance talk for independent thinkers who prosper outside of Wall Street. Here’s your host, bestselling author, Kim D.H. Butler. Welcome to the Prosperity Podcast. Today we’re going to be talking about interest and why you shouldn’t be paying interest and you should be earning it. Are you there with me, Kim? Yes, I am, Spencer. This is a fun topic and especially because we’re living in a world of roller coaster interest rates. So let’s dive in and start talking about why we should be earning that interest instead of paying it. Well, it is so interesting how disconnected we are as human beings from the concept of time value of money.

[01:04] Time value of money basically says money does not work in a vacuum. In other words, if you have dollars, you are either paying interest or I should really say you’re paying up interest or you’re passing up interest. With full credit to a friend of mine and Todd’s from Louisiana who says it’s pay up or pass up. Yep, yep. I’ve heard that phrase. Yep, kind of a good way to remember it. This relates to the time value of money and so it works like this. If you have dollars that are in cash, it could be $10,000, maybe $100,000. It doesn’t matter. Your own money, your own dollars have a cost and a lot of people think that If they, for example, pay cash for something, then there is no interest cost, but that

[02:04] is not accurate because if you pay cash for something, what you’ve done is you’ve passed up interest. You have foregone the interest that you could have earned. The reason that it’s so confusing now as we sit here and talk about this in 2018 is that most people’s savings accounts or any place that they would store cash frankly isn’t really earning any interest and after you pay taxes and fees at the bank or what have you, definitely not earning any interest. But if we think about a more normal time when let’s say savings accounts earn 5% and let’s say that you had this $100,000 and you went and spent $40,000 on a car, it is not accurate that you have no interest cost. What you’ve done by paying cash, you’ve avoided an interest payment.

[03:03] In other words, you don’t owe interest to anybody, but you have not avoided an interest cost. And the $64,000 question for you to get an A on your quiz is what is your interest cost? So I’m going to put you on the spot, Spencer. Do you know the answer? Interest cost? Well, I’m going to stab at it, OK? And I’m probably going to get it. I’m going to get it wrong because we’re live. But we’ve got to factor in inflation. Yes. And then we have to factor in the missed opportunity of whatever that would be. Yes. And so because your money was sitting in a 5% account, let’s just first identify the opportunity cost. Do you know the answer now? The opportunity cost on that, if it’s at a 5% sitting there, we’ve lost 5%.

[03:55] Exactly. It’s really more simple. Go ahead. So we’ve lost at least 5%. But then my mind is starting to race towards and this is where it just goes off into the different puzzles. And I go, OK, well, some car loans are 0% interest. And then I could go and do a bridge loan or an alternative investment and get 7. So yes, absolutely. I see where you’re at. So it really is at the first level. It is that simple. If you have a 5% account, you pay for something in cash. You have lost the opportunity to earn 5% on that money. And that’s very obvious. You had it in a 5% account. You took it out. And now it’s not earning that 5%. But you picked up on something that is very important. And that is if you had an investment that could earn 7%, then technically your

[04:51] opportunity cost that you are giving up is at 7%. Now, that’s pure math. And we’re going to set inflation aside for a minute because everything is affected by inflation. So there’s not a lot we can do about that. But if we’re just looking at opportunity costs, the definition of it truly is your highest and best use. It’s your highest investment. That’s your measured opportunity cost. Now, again, as I said, that’s like pure financials. It’s not taking into consideration real life because, as an example, you need to have your emergency opportunity fund. We can’t have all of our money in this awesome 7% investment. You have to have savings or your emergency opportunity fund or your family is subjecting

[05:37] itself to more risk. So we understand that some of our money is going to be at a lower interest rate for the peace of mind that emergency opportunity funds enable us to have. But we also need to understand that just because there is, quote, no interest payment does not mean no interest cost. Now let’s circle back around to your 0% car loan statement. OK. Let me ask you another question. I’m having fun putting you on the spot here. Are you having fun? Well, you know, I’m the one that likes to ask the questions, but I think I’ll take the hot seat for a moment. OK, awesome. It’ll help our listeners. So it’s totally worth doing. You’re taking one for the team. So if you have an opportunity to get a 0% car loan and you step back for a

[06:32] minute and you think about this question, do the car companies make more money from manufacturing and selling the cars or from financing the cars? How would you answer that question? Well, at 0% interest, it is not from financing the cars. Correct. And yet if you look at the balance sheet and income statement of a car company, they make massive amounts, more money from their financing arm than they do from their manufacturing arm. And so we have to think about this a little bit deeper. And my husband likes to say, if something sounds too good to be true, it’s not that it may be that way. It’s just that you’ve got to dig in a little bit deeper and figure out whether it is actually too good to be true or whether there’s something there

[07:30] that you’re missing. And so what we’re missing in this discussion is a very common thing that us humans just seem to forget about. And that goes back to this cost of money, time value of money idea and what the car finance companies are doing. And so what they are doing when you see advertisements for a 0% car loan is they are adding the interest to the price of the car and then dividing that out and creating your monthly payment and calling it 0% interest. So let’s say they go to the manufacturing division and the manufacturing says, look, this car, we can sell it at a profit for 30 grand. And of course we want them to make a profit. You know, if they don’t make a profit, they don’t stay in business.

[08:20] OK, so if manufacturing says they can sell it for 30 grand, then they go to the financing division and the financing division says, well, we would earn about $5,000 in interest. And so what they will do is sell the car for 35,000, but call it 0% interest. Now, isn’t it great? Now, I’m going to be vulnerable for a moment and explain it since I’m in the hot seat today. You know, for our family, over the last, oh, gosh, it’s been 10 years. All of the vehicles that we’ve purchased, we’ve paid cash for. And it’s just because of wanting to be financially prepared and to live a very prudent lifestyle. After I went to the truth training, I remember coming home and talking to my wife and saying, hey, we’ve been doing this wrong.

[09:14] So I can understand some families out there that truly want to have that financial peace of mind. You know, when it comes to mortgages, paying off a mortgage early, there are some people that just sleep better at night that way. But when you understand the numbers, it’s a totally different scenario. Absolutely. And so we have a book on this, as you’re aware, that is called Busting the Interest Rate Lies. And it helps somebody understand the pure financial math behind interest rate environments like mortgages and car loans. Now, I understand sometimes peace of mind does override pure financial math. And yet, when you become aware of, for example, alternative investments that could earn 7% or 8% and you can be confident in them, then you

[10:12] can make decisions about both mortgage interest rates, which tend to be around the 4% to 5% range today, and car loan interest rates. And I’m not talking about the 0% fake ones. I’m talking about a true, like, go to the bank and what do they charge for car loans? And it’s around the same 4% or 5% for a new car. And we can be more conscious of our decisions because really what bothers us on the mortgages and on the car loans is the payment, right? It’s not really the mortgage itself. It’s the mortgage payment that we don’t like, right? Absolutely. And it’s not the car loan itself. It’s the car loan payment that we don’t like. And so, again, we can understand that, hey, this, just call it 35,000,

[11:01] you know, picking up on our earlier example, this $35,000, I could, now this is assuming I have my emergency opportunity fund already in place, I could take the 35,000 and invest it at, say, 7% or 8% and be confident in that investment. Or I could take the 35,000 and essentially wipe out a 4% cost. Well, if you step back at that and you’re looking at just the pure financial math, it’s clearly better to have an investment at 7% than it is a cost at 4%, like a car loan that would cost 4%. And again, I reiterate, that’s pure financial math. And yet, there are some families, yours may or may not be one of them. We’ll see what happens with you going forward that say, I understand financially I would be ahead with my 7% investment and my 4% car loan,

[11:57] but I cannot sleep at night that way. And the reason that you can’t sleep at night that way is probably because you don’t have a good emergency opportunity fund. But even some families that do have an emergency opportunity fund, and I’m sure that you do, still, for whatever reason, do not like the idea of debt. And so I always want to help people understand that there’s a difference between being in debt and having debt. Being in debt is when you have a $40,000 credit card balance and no money to your name, and maybe you don’t even have a job. That’s a realistic scenario for some people. Or even if you have a job, there’s $40,000 of debt and no corresponding assets. That’s being in debt. Having debt is when you choose to have a $35,000 car and a $30,000 car loan,

[12:59] or a $250,000 house and a $210,000 mortgage. That’s having debt. And that’s a very important distinction. And then again, when we go back to our interest rate discussion and we can figure out that the absolute financial efficiency is having our monies invested at the higher interest rate and then at debt at the lower interest rate. And that efficiency is there. Now, again, peace of mind may override it, and that’s fine. But true financial efficiency is going to say invest your dollars at the higher interest rate investment and then go ahead and take on the debt. That is a great way to look at it. It’s difficult as a responsible couple or a young family to fully realize the picture. But when you have a long-term picture to the entire puzzle

[14:04] and you understand that we’re going to be around, could be well over 100 years, what you say makes a lot of sense. Well, thank you. I really want to give my husband, Todd Langford, the kudos for that because I struggled with these concepts. I was trained as a typical financial planner. And I did not believe that the mortgage was best at 30 years. I thought it was best at 15. And I also believe that paying cash for cars and whatnot was a good, responsible way of being. The challenge is, you guys are doing a good job of saving money up for your vehicles, and then you’re spending all of that money on the car. And so you’re starting over every single time. And you can use the life insurance instead to build an asset up,

[14:54] and it could be your, quote, car account, and then borrow against it and buy the car. And in that way, you could still technically buy the car at the dealership for cash, and then you’d have a, quote, car loan to your life insurance company. Now, you do always want to look at interest rates. And right now, there’s a chance you’d better be, you’d be better off doing your car loan at the bank because car loans at the bank right now are 3% or 4%, whereas your life insurance company is going to charge you probably 5% or 6%. So you do have to look at interest rates. Nevertheless, the whole idea of borrowing against the cash value and then paying it back and then borrowing against it again and paying it back again and borrowing against it again

[15:40] and paying it back again, that will enable you to have an uninterrupted compound interest curve. And that’s just basically a fancy way of saying your savings account will keep growing even though you’ve borrowed against it to buy cars because as we’re clear, you’re borrowing against that cash value. You’re not borrowing from it. But again, I reiterate that interest rates do matter. And so in today’s world, you’re probably off doing, probably better off doing your car loan at the bank with a lower interest and then just keeping your cash value growing and borrowing against it to do investments rather than debt. Absolutely. Great way to put that. And, you know, for our listeners, if you want to learn more about this,

[16:28] you can check out Kim’s book Busting the Interest Rate Lies. That one’s on Amazon, is that correct? In both read audible and e-book, is that correct? That’s correct. Yes. Physical book, audio and Kindle. Oh, excellent. So there you go. Whatever way works best for you for learning. I’ve got the book right here next to me. You can hear me flip through the pages. And it is worth it is one worth learning for me to be, you know, Spencer on the spot today. I will say that I’ve had to correct some of my plans. And in fact, here’s something that I haven’t even said. The next house that we’re doing, we’re you know, we’ve typically been paying cash, so I’ve owned property. But the next one we’re actually doing with the intention of making it

[17:17] an Airbnb house and we’re doing a mortgage. So for a cash flow perspective. So there’s totally different ways to look at this new puzzle. And I encourage everyone to educate yourselves as much as possible. Fabulous. Well, any questions can come my way. And that’s hello at Partners 4 Prosperity dot com. Thank you for listening to the Prosperity podcast. To take control of your money and have it work for you. Visit us at Partners 4 Prosperity dot com. If you liked this episode, make sure you subscribe and leave a review.