I will preface this post by saying: we do not give loans. Everything you are about to read describes how banks do things. We are not a bank. We do things differently (better). We install equipment in buildings for free, and charge for the clean energy it creates or saves. That is it. What we do is simple, easy, and transparent. What banks do is not. But everyone has had a loan from a bank at one time or another, so we thought it best to explain how traditional financing works here. Spoiler alert: we explain at the end how to reduce debt.
Here is the basic premise of financing: you want to invest in something that will make you lots of money, say, a golden goose, but you lack the upfront capital buy it. No problem, a bank will finance it for you. This means the bank will loan you the money you need to buy the goose, and then you sell golden eggs and use some of the revenue to pay the bank each month until they recollect their cash and some profit. Sound simple? It is. Kind of. Here is what is really going on:
When the bank loans you money, they try to figure out how likely it is you will default. In other words, they try to guess the probability the golden goose you are buying is a fake, or that you will otherwise fail to make any money from selling eggs or from whatever your venture is. This is called your default rate, and for most businesses it is pretty low (a few percent).
After determining your default risk, the bank then looks at what return they would get on a completely risk free investment. No investment is risk free, you say? True, but banks (and you) can loan money to the United States government, which is pretty close to riskless. The way to loan money to the Federal government is to buy treasury bonds. A treasury bond is a slip of paper that says the government will pay you a set amount of money after a set period of time. For example, you could buy a bond that says the government will pay you $100 one year from now. Banks (and people) can bid for these bonds in auction, so you might be able to purchase an $100 bond for only $95.24 bucks. This then tells you that the risk-free interest rate is five percent, since 95.24 dollars plus five percent of $95.24 equals 100 bucks.
After adding your default rate to the risk free rate, the banks adds a little profit margin (say, another two percent), for themselves in case things go wrong to come up with your overall interest rate. This overall interest rate, the sum of the risk free rate, your default rate, and a profit margin, is what the bank charges you. This overall interest rate is also called the discount rate. Seem a little convoluted? It gets worse.
To make things “simple,” the bank wants you to pay the same payment every month, so they plug the discount rate into a formula to come up with a Capital Recovery Factor. The formula is (do not quit now, we are almost done!) , where ‘i’ is the interest rate and ‘n’ is the number of payments. So if the loan is an 8 percent loan for 20 years, your Capital Recovery Factor is .
Okay, why care? Here’s where it gets simple again: To find your annual payment, simply multiply your annual Capital Recovery Factor by the amount of money the bank loaned you: if the bank loaned you $10,000 at 8 percent for 20 years, you would owe 10,000 * 0.10185 = $1,018.50 per year, or $84.88 monthly.
But you pay that for 20 years. So for a loan of $10,000, you will pay the bank a whopping $20,370! That’s more than twice what you borrowed, even though your interest rate was only 8 percent! So great, we have done lots of math to determine banks make out like bandits. You could have guessed that without the math. Let us dig just a tiny bit deeper to find out how you can save your hard-earned money.
A year after you borrowed $10,000, you will owe the bank $10,800 since you are paying 8 percent interest. At the end of that year, when you give the bank your $1,018.50, your ending balance with the bank will be $10,800 – $1,018.50 = $9,781.50. That means 79% of your first year’s payment went to paying interest alone! Under the bank’s standard payment plan, you pay almost exclusively interest for years. After 7 years, you still owe the bank more than $8,000. In other words, after seven years, you will still owe the bank 80 percent of what you borrowed. The table below shows the cash flows over the entire course of the loan.
|Year||Payment||Interest||Principle Paid||Loan Balance|
To save yourself a lot of golden goose eggs, pay the bank some extra money early on. This way, you can pay down your principle right at the beginning, and instead of paying almost all your money just to keep up with interest, you can prevent a lot of that interest from accruing in the first place. If that $10,000 project you borrowed money to invest in goes well, think about giving the bank an extra $500 each year for the first four years. You would pay an extra $2,000 early on, but over the life of the loan, you would only pay the bank $19,111.30 total; $1,000 less than the bank originally had you for. By paying $2,000 extra over the first four years towards your debt, you save a full $1,000: a 50% return.
The chart shows your principle balance over time, under the standard plan in blue, and under the accelerated plan in red. The area between the two lines is the total value of your savings.
In summary: banks provide a great service – cash when you need it – but they take a large return for themselves while doing so. If you have a loan and your projects are going well, do what you can to pay more than the standard payments. Just be careful; when you send the bank extra money, you have to tell the bank it should be applied to the principle directly and is not simply a prepayment on future standard payments.
So there you have it, bank loans demystified.