Today my time with Master Song was most interesting. As you could tell from reading the very scholastic post here, you'll see that I was inspired to dig into the important topic of compound interest. Now that I've started that thread I wanted to move on and present to you what he did to me. It was a shameful experience but I love those experiences because they are memorable and one actually learns through being shamed. Wow! New idea! Shame children during school to help them learn better! Ok. Maybe not.
The question that shamed me and got me on this was this (and try to think about it before reading the answer. Be sure you have a position):
If Bank A would lend you $100 at 5% and their savings account was only offering you 4%, but bank B would give you 7% in their high interest savings account, would you borrow the $100 from Bank A to put it into Bank B? Why, or why not?
...think...
...think a little more...
...my answer was 'Yes. That's something I would do."...
...think...
Ok. So you know I was shamed so my answer was obviously wrong.
Why, though? Why not do that? The answer is found in the way that the compounding works. Apparently (and I hope to run some scenarios in a follow up post when it isn't 1:15am) savings accounts are compounded quarterly or annually. I always thought since they pay you monthly that they are compounded monthly. How wrong I was apparently. Loans, on the other hand, are compounded monthly.
So, the theory is that if you borrowed at 5% and you are paying interest monthly, that you'll end up paying more than the 7% (Perhaps much more?) at Bank B.
For investors, this is really nasty important. These leveraging guys out there... They may be even more off-base than I originally thought.
Did I ever tell you I had a guy who tried to get me to leverage 25K to just put in some random mutual fund with hopes that it might make 7-10% 'over the long haul'? haha.
Well, that would have been better than my random stock purchases. :(
By the way... Master Song strongly approves of our blog idea as a way of increasing our knowledge base. He thinks that within 5 years we might be ready to start, hehe.
We live. We learn.
And if we don't learn, we don't invest.
T1 out.
B.L.I.P. Heros
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3 comments:
One thing to consider is the tax benefits of borrowing to invest - this means that you are effectively paying about 3.5% interest on the loan from bank A...
(Thats assuming a marginal tax rate of 30% which translates to an annual income of $38,000 to $70,000 in BC - http://www.taxtips.ca/marginaltaxrates.htm)
If you borrowed $100,000 from bank A and invested in the savings account at bank B, your annual profit would be approx $4450.
If you have the spare credit capacity its a winning bet, but I would expect creative, knowledgeable investors such as yourselves could do better than that with $100,000 in unsecured borrowing power.
Oh Rayban, I see you shaming mine enemy time and again. And I wonder if I conspire within the walls of my camp, if you could be inducted into the BLIP hall of fame. Mr. Taylor #1 (or wayne as I shall call him) has brought his own team player, while I've been fending for myself. The one thing I have on my side is that I am 99% right, but now I need numbers. Team playas. A crew. A Bro...in law.
You should turn Master Song onto our blog. I think maybe even HE could learn something.
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