Two stories that illustrate why it is so important to pay attention to and distinguish principal from interest and assets from cash flow.
I dedicated the last four blog posts to a single story about paying off debts. You might wonder why I would spend so much time in the subject.
Why Does Liza’s Story Mean So Much to Me?
I think two stories from my family’s life will explain at least part of the answer better than any essay.
The Emergency Fund
My wife and I worked for a non-profit agency for about 8 years. We had to raise our own “support.” In other words, we had to ask people to donate to the organization in our behalf so the organization would give us money to live on.
Well, I hated to ask for donations. Which meant that we lived on very little for all those years.
In fact, from 1984 through 1989, our income averaged just under $14,400 a year.
We had an emergency fund we had built up. During out last two years in grad school, we ran the dining club on campus and had been able to salt away $10,000.
Sometime early in our career at the non-profit, Sarita told me: “If we ever dip into that emergency fund so that it goes below $10,000 . . . we’re out of here!”
I will confess, toward the end of our time there, I started wondering whether we would find ourselves having to dip. And as that possibility loomed before me, I began to think about what it means to have an emergency fund.
As long as we had that $10,000 available, we could move to another place. We had time to find another job. And as long as we had those options, we were not poor. Certainly not poor like those who have no options.
Having an emergency fund meant we had stability. We had options.
Total poverty means having no options.
When you have no options, you are living in abject poverty. You have no buffer. No protection from the vicissitudes of life.
We had options. We were not poor.
I was appalled at Mr. Cardon’s advice to Liza because he was urging her to destroy her emergency fund. He said that, once she got out of woods with her negative cash flow situation, he would encourage her to create an emergency fund. My concern: Why didn’t he recognize that she already had an emergency fund that could readily meet her cash flow needs? And why would he counsel her to destroy her fund when it was so unnecessary?
The Case of the Miscalculated ROI
I helped our sons acquire Partial Notes (five-year portions of income from “vendor finance” mortgages that, prior to our acquisition, had been paid on for at least six months). See How Partial Notes Work to learn the basics of what I’m talking about.
The company that helped us acquire the notes sold them to us on the basis that they would yield just over 10%.
That sounded good to me! And a cursory glance at the numbers made it clear that my sons would, indeed, make 10% on their investments.
A couple of months later, however, after he received his second payment, one of my sons emailed me: “Am I making a 30% annual yield?!?”
Facts: He had invested $25,416. And he was receiving $637.16 in monthly payments on the property.
He showed me his math: “($637.16/mo * 12mo/yr) / $25,000 = 30.5%.”
I knew he wasn’t making 30.5%, or anything close to that, but it took me a while to figure out why his math was showing such a high number . . . and how high the number should really be.
Eventually, I wrote him back:
Don’t Forget Return of Principal
The $637.16 monthly payment you’re receiving includes return of principal. So you have to multiply $637.16 * 60 months = $38,229.60 total payments over the course of your five-year ownership.
Once you subtract the original investment (which was $25,416), that leaves $12,813.60 in interest. Divide $12,813.60 by 5 (years); that gives you $2,562.72 in interest each year. Now divide that by the value of your original investment, and you have an effective rate of 10.08%.
That’s how [the company that sold us the note] calculated the returns.
HOWEVER . . . to calculate your total returns as if you never received any payments until the end isn’t really accurate. Because you’re actually receiving principal and interest throughout the term of the loan. And you’re getting a higher proportion of interest than principal at the beginning. . . .
So the amount of money on which you are receiving payments is constantly decreasing. Put another way, you have the ability to REINVEST all of the principal that you are receiving as you receive it. You can actually multiply your investment!
I don’t know how to calculate these things myself, so I went to an amortization calculator and plugged in $25,416 of Principal, 12 Payments per Year for a total of 60 payments, a Payment Amount of $637.16 and a $0 Balloon Payment.
The calculator came back with the following loan summary (from the perspective of the BORROWER):
Principal borrowed: $25,416.00 Regular Payment amount: $637.16 Final Balloon Payment: $0.00 Interest-only payment: $368.57 Total Repaid: $38,229.60 Total Interest Paid: $12,813.60 Annual Payments: 12 Total Payments: 60 (5.00 years) Annual interest rate: 17.4020%
I thought: “That’s crazy!” . . . But if you zero out the monthly payment and leave the 17.4020% Annual Interest Rate . . . the $637.16 monthly payment is exactly what it calculates.
Just to be sure, I went to another amortization calculator, and it gave me the same 17.402% interest rate.
So I was very curious how you could possibly be making 17.402%. . . . I finally figured it out.
Take $368.57 (which is the amount of interest paid on the first month’s payment) and multiply it by 12 (to get the value of the full year’s payment). You wind up with $4,422.84. Divide that by $25,416 (the total amount borrowed and on which payment was being made), and you get an interest rate of 17.40179%. . . . .
Just in case there was something fishy in that calculation, I took the last month’s interest payment of $9.11 on a balance (at the beginning of the month) of $628.05.
I multiplied $9.11 by 12 and wound up with $109.32. Divide that number by $628.05 and you have an interest rate of 17.406257%. . . .
So you really are doing remarkably well! Not 30.5% . . . but way, way better than I ever thought possible. . . .
Point in this story: I was smacked in the face with the significance of interest v principal. We must always distinguish the two, always take them into account.
I intend to return to these themes at a later date. The issues raised in today’s stories become especially important as we figure out how to pay off our house mortgages.