Let’s see if we can figure out which investment is better – from a lender’s standpoint:
Scenario A – $100,000 loan @ 10% interest only for 10 years
Scenario B – $100,000 loan @ 10% interest amortized over 10 years
Scenario A represents 10 years collecting $10,000 per year in interest, for a total of $100,000 in interest. Add that to the $100,000 in principal paid back at the end of the term and you have $200,000 in the lender’s pocket after 10 years.
Scenario B is amortized over the 10 years, so a portion of principal is paid off in every payment. This equates to a total of $158,581 in the lender’s pocket after 10 years.
Obviously, Scenario A is the better investment… or is it? In Scenario A, the lender ends up with $200,000; in Scenario B, the lender ends up with only $158,581.
The other day, one of my investors said to me, “You know, that amortized loan that you say yields 10% only yields 5.85%. Look at what you end up with after 10 years on a $100,000 loan: $58,581. So it only made 5.85%.”
Even though I knew that wasn’t right, he caught me off guard and I couldn’t think of how to explain why he was mistaken. I felt bad because I should know this stuff well enough to explain it easily, but no one had thrown me that curve ball before.
The answer is simple, and you may already know it. In an amortized loan, the payment received each month is greater than the interest owed because a portion of each payment goes towards the principal. This allows the borrower to pay down the loan to zero by the end of the term. Okay, duh, we all know that. But did you get what I said there?
For Scenario A, the monthly payment would be $10,000 divided by 12 months, equaling $833 per month.
For Scenario B, the monthly payment would be $1,321 amortized over 120 payments, totaling $488 more per month than Scenario A. That’s $488 times 12 months, equaling $5,856 more every year.
Mathematically, they both have a 10% yield. No argument there.
But with Scenario B, the additional $5,856 received yearly can be reinvested. You might ask, “Where do I put $5,856 per year, or $488 per month, to continue getting a 10% yield?” That is a legitimate question, and a good argument against Scenario B.
The argument against Scenario A is that the lender is taking a much bigger risk in getting his $100,000 principal back after 10 years. Why do you think banks only do amortized loans? They don’t want the additional risk. They want the principal to be paid down every month to negate some of the risk of not getting their money back. In Scenario A, the borrower must make sure he has the pay-off in the end for the final balloon payment. Giving the borrower that responsibility can be scary for the lender.
So, which scenario is better? It depends on the situation. Do you feel totally confident that the borrower will be solvent enough to pay your principal back in the end? Then Scenario A could be right for you. If you would like to remove the risk and can find other investments with returns that suit your investing goals, then probably Scenario B would be best.
Investing decisions are rarely black and white; there are too many variables involved. Whichever scenario you prefer in this comparison, you can be sure that they both pay a 10% yield in the end.