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Effect of Inflation on Bank Loans
 
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Effect of Inflation on Bank Loans
Borrowing money from banks at zero interest rate? Milan Doshi shows you how
Posted Date: May 14, 2010
By: Milan Doshi

Effect of Inflation on Bank Loans

Borrowing money from banks at zero interest rate? Milan Doshi shows you how

If you were to ask any person from our parents’ generation, the common advice they would give is:

  1. Don’t borrow any money

and

  1. If you really need to borrow, borrow as little as possible and return it back as soon as possible

Their reasoning is that having a peaceful sleep at night is extremely important. If you were to owe anyone any money, there is this deep-rooted fear that someone might knock on your front door in the middle of the night demanding that they be repaid on the spot.

I am not too sure but perhaps it could partially be due to movies. In many movies, there are scenes where the greedy landlord and his henchmen come knocking on the poor farmer’s door demanding that they be repaid on the spot. When the poor farmer is unable to do so, the landlord then forcefully takes over what few possessions the farmer has and kicks the poor farmer and his family out of the house.

There is no way we can fully appreciate what our parents might have gone through in their generation which shaped their beliefs. Many of them would have lived through the Second World War, the OPEC oil crisis, racial riots, etc. In those days, being able to have 3 decent meals a day was a luxury, something that we today take for granted.

Leveraging on bank borrowings

As a result of this misplaced fear, many of our parents have completely missed out on the power of leverage by using bank borrowings for property investments. In fact, I recall the day my father bought a double-storey house in Singapore in 1973 for S$120,000 which was a big sum in those days. He had taken a 25-year loan and one of his life’s goal was to look forward to the day the property loan is fully settled and the house finally becomes his. The loan was finally settled in 1998 and my father sold off the house for around S$1 million a few years later and moved into a condominium as both my parents had trouble climbing stairs.

Another reason why their generation didn’t like to take up big bank loans for property purchases is that the amount that has to be repaid back over long periods is close to double the original loan amount. They prefer to work hard, save money for a few years and then take a small loan to save on bank interest costs. Unfortunately, their well-meaning advice given while we are growing up makes many people afraid to take on big loans. Hopefully, this article changes your perspective on this issue. 

Are bank loans making you poorer? 

Let’s take the example of a loan for RM1 million at a fixed interest rate of 5% per annum for 25 years. The yearly installment works out to RM70,952 per year or RM5,913 per month. Multiply by 25 years and the amount works out to a staggering RM1,773,800! Imagine borrowing RM1 million but having to pay RM1.773 million back i.e. the principal amount of RM1 million plus interest costs of RM773,800. As a result, many people would rather avoid borrowing money and hence miss out on property investments. Their logic would be “Why take unnecessary risks to make the banks richer and yourself poorer”?

Unfortunately, these people are looking at things from the wrong angle. They don’t realize that the money returned back while in absolute terms is totalling RM1.773 million, its value after taking inflation into account is completely different. You are not paying RM1.773 million today, but RM70,952 per year spread over the next 25 years. The purchasing power of RM70,952 today and its value 5, 10, 15, 20 and 25 years is vastly different.

For readers who are not mathematically-inclined, let me first explain the effects of inflation in an easy manner. Let’s assume RM1,000 today can buy you 1,000 lollipops. If inflation is running at 4% per annum, the value of

                                                    1,000 lollipops
RM1,000 one year from now  = -----------------------
                                                      1 + Inflation Rate

                                                  1,000 lollipops
                                              = ------------------------
                                                      1 + 4% (or 1.04)

                                              = 961.5 lollipops

Hence RM1,000 one year from now can only purchase 961.5 lollipops. Therefore, the value of RM1,000 one year later is the equivalent of RM961.5 in today’s value if inflation is 4% per annum.

                                                       Value of RM1,000 one year from now 
RM1,000 two years from now  = -----------------------------------------------
                                                                      1 + Inflation Rate

                                                         961.5 lollipops
                                                = -------------------------
                                                        1 + 4% (or 1.04)

                                                                    1,000 lollipops
                                              or   ------------------------------------
                                                        (1 + Inflation Rate)2  or 1.042

                                              = 924.5 lollipops

Therefore, RM1,000 two years later is only worth RM924.5 in today’s ringgit.

The formula to compute the Present Value of Future Dollars is:

                                                                                    Future Amount
Present Value of Amount nth years from now =  ----------------------------
                                                                                (1 + Inflation Rate)n

Let’s compute the Future Value of RM70,952 per year over the next 25 years assuming the inflation is 4% per annum:

Year                Amount (RM) in Present Value
   1                     70,952 / (1 + 4%)1 = 68,223
   2                     70,952 / (1 + 4%)2 = 65,600
   3                     70,952 / (1 + 4%)3 = 63,077

Calculate until Year 25 and add up all the various Present Values gives the answer of RM1,108,425. What this means is that while we will be paying in absolute terms a total of RM1.773 million, the actual value after inflation at 4% per annum is only RM1.108 million. Suddenly borrowing money doesn’t look so scary.

In fact, it will start to make even more sense. Study the table below for the Present Value of a loan of RM1 million for 25 years at interest rates of 4% and 5% for various inflation rates:

Notice that if your bank interest rate is 4% (or 5%) and your inflation rate is 4% (or 5%), the Present Value of the Total Installment paid over 25 years will be equal to your bank loan of RM1 million. The bank interest cost and inflation cancels each other out. It’s equivalent to borrowing money at zero interest rate!

Inflation cancels out bank interest cost

If your personal inflation rate is above the bank interest rate, you actually end up paying less back. For example, if the bank interest rate is 4% (which is the current rate of BLR – 1.8% for residential properties) and your inflation is 5%, you actually end up paying back RM902,181 for a loan of RM1 million. Unbelievable, but it’s true.

Malaysia’s official inflation rate is around 3% per annum. Unfortunately this is not what most of us experience on an annual basis especially in recent years. Most families’ inflation rate will hover between 5% – 10% per annum depending on the parents’ (around 4-6% pa) and their children’s (around 6-10% pa) lifestyles. The inflation rate for children is usually higher than their parents due to their different consumption pattern and spending habits. This higher inflation rate actually works in your favor as the bank interest cost is only 4% per annum (i.e. BLR – 1.8%), far below your family’s average inflation rate.

In property investments, inflation not only works by pushing up asset values. It also reduces your borrowing costs when inflation is taken into account! This is another powerful reason why you must invest in good investment properties and borrow as much as possible provided the yields are higher than your borrowing costs. Then sit back, relax and let inflation work its magic on both sides of your Net Worth.  

If you have any comments on this article or questions, please email to me at http://achievers88@yahoo.com. I would highly recommend that you sign up at our moderated getrichbook egroups at:
 
http://finance.groups.yahoo.com/group/getrichbook/

It's free for all my book readers and readers of this article. Only relevant emails pertaining to finance, property and stock investments will be approved for broadcast.

Article Contributed by
Milan Doshi
Financial Trainer and Best Selling Author of
“How You Can Become a Multi-Millionaire Real Estate Investor!”
For more information, visit www.milandoshi.com

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