Over the last couple of days there was a discussion related to the payoff amount for a loan, the interest rate and what to do. It worked out the investor has the cash so could pay off the loan in one lump sum. Or the investor could continue to make monthly payments. Two different themes emerged from the discussion that I want to highlight here.
First, the investor had no clue how to calculate the interest rate and the amortisation schedule. It might be argued that this was not that critical as the investor knew the lender was charging 18%/pa. Why it became a problem is they had confused themselves into thinking that because the amount of interest paid over the last few years of the loan was less in total than in the early years, the interest rate must be going down. They assumed, incorrectly as it turns out, that the lender had charged a higher rate than 18% in the early years and the lender was charging a lower rate in the later years to produce a blended 18%.
The flaw in this thinking was they held the outstanding principal constant for the remaining years and divided the interest for the remaining years into the current principal amount.
Bottom line is they had no clue about compounding and loan amortisation. Maybe an esoteric topic other than the fact that as a real estate investor their biggest tool is OPM. If you are going to use OPM you really need to understand how much you are paying for the OPM.
The higher level issue was should they continue to pay monthly and invest the cash or use the cash to pay off the debt bow. That appeared to be an easier topic to discuss as it really comes down to the rate of return the cash can earn invested in some other opportunity vs. reducing the debt. A related topic is the credit score and how it is impacted by the existing loan vs. paying off the loan.
In the end, the decision is about the opportunity cost of not having liquid cash vs. the 18% and the related credit score movement. Initially the investor miscalculated the interest rate and thought they only had to do better than 9% to be ahead. After clarification as to how to calculate the rate correctly, they understood the hurdle was 18% plus the other side effects.
Do you know how to use a calculator or spreadsheet to calculate a loan amortisation? If not, is this something I should take some time to explain? I consider loan calculations a required skill set for any real estate investor who wants to grow their investment portfolio. A tool of the trade so to speak.
In any event, do answer the question and let me know if you need some help.