Today, anything can be purchased with a loan. A house, a car, a TV set, furnishings for your apartment, even groceries. Shopping with money that is not ours has become an everyday aspect of our lives. The situation gets blurred even more thanks to the inventiveness and creativity of the financial institutions in the words they come up with to label loans. Terms such as mortgage, consumer credit, overdraft, credit and revolving card, instalment purchase or leasing – all of them always mean the same thing – a loan.
Make sure to do the maths
One can even invest through a loan. Margin, a Lombard loan or an overdraft: these are names that are often used for loan investment. We would like you to be alerted to a practice implemented in some institutions – we may as well call it “virtual loan investments”. So, what is it about?
A financial institution sells its client a share in a mutual fund for, say, a 100 thousand euro. According to the realistic scenario the institution presents, this fund can make the client 6% annually. Simultaneously, the institution offers the client a loan (an overdraft, for example) secured by this very mutual fund; the loan amounts to 80 thousand euro with 4% interest rate annually. At first sight, this is a great deal, right? It is, if we don’t take fees into consideration. As always, the devil is in the details. Let’s calculate who is going to laugh last at the end of the day.
Regardless of whether the mutual fund makes you money or not, the financial institution will make money on the administrative fee they charge you, e.g. 1.5%, that is, €1,500 per year. From the interest rate margin on the loan, the institution will gain, say 2% p.a., which is another €1,600 per year. This makes €3100 (that is, more than 3% of the investment amount). Besides all of the above, the client will also have to pay large entry fees and a loan processing fee.
Let us assume that the above mutual fund will perform at -4, 0, 4 or 8%. The client will invest the funds obtained from the acquired loan into a very attractive investment opportunity that will bring in -4, 0, 4, 8 or 12%. How will the client fare in the end?
Sometimes the client can be doing better, sometimes worse. Essentially, as a rule of a thumb, unless his or her total investment valuation exceeds 4% (the orange cells), the whole of this investment scheme is worth nothing to him or her.
Fees several-times lower
Let us, however, try to do the same but in a different way. From the 100 thousand euro you have, you invest 20 thousand in a mutual fund and the remaining 80 thousand into the above-mentioned attractive investment opportunity. How much will the financial institution earn on this particular scheme? Let’s do the maths.
The financial institution will earn €300 (1.5% x €20 thousand) on the administrative fee and zero profit on the loan margin. So, the total is €300, which is ten-times less in comparison to the previous example! Besides – the client will pay five-times less on the entry fees (you only invest one-fifth), and you pay nothing for the loan provision.
Let us now look at how the client’s going to fare with this alternative.
Well, the client is certainly better off now – he/she has lower potential losses and logically, also lower gains, but above all, pays lower fees! It is the fees that are among the key factors that significantly influence the value of any investment in the long-term perspective.
So, if any financial institution offers you a loan investment without you really needing this instrument or asking for it outright, you had better run away, and quickly! There is nothing else behind it, apart from their effort to ‘leverage’ a little more on fees and charges.