Personal loan or pre-purchase amortization when and what is convenient

An alternative that is often not thought of, an idea different from financing that involves total savings of interests and requires good self-control of expenses. A provident system but not suitable for everyone.

Amortization fund

Amortization fund

The principle of depreciation in the company works like this: before starting with the activity we estimate everything you need to start and buy or rent. In the case of purchase, the capital will be shifted from liabilities to assets, constituting what is called an asset. The purchase of an asset automatically generates a fund called the Amortization Fund ; in essence it is a kind of piggy bank in which the company will pay a fee each year as an installment called the amortization rate. The purpose of this fund is to establish a suitable capital to repurchase the asset when necessary.

The depreciation fund is calculated by subtracting from the presumed future purchase value of the new asset, the commercial value that it will have at the time of disposal. For example, if I buy a machine for 100,000 USD I value and that for me it will be fine for 3 years, I have to calculate how much it will cost about 3 years then 100,000 USD more upside of the market which we assume cautiously equal to 10% then in our example 110,000 USD.

Let’s suppose also to estimate to resell the good after 3 years of use to 50% of its initial value; in this case 50,000 USD. To repurchase the asset, at the end of the 3 years we will need a fund of 110,000 – 50,000 = 60,000 USD. Therefore I will divide this value in the 3 years and will trivially put in the fund a quota equal to 20,000 USD / year.

In this way every year I have set aside a quota which will constitute at the end of the useful life of the asset, the countervalue for its replacement.

In the case of a leased asset there will be no fund but the amortization quota will be replaced by the lease payment increased by a supplementary amortization in the rare case in which the asset is to be redeemed at the end of the leasing contract.

Loan purchase

Loan purchase

Now let’s try to transfer this concept designed for companies and for the purchase of capital goods, to the normal consumer. The best way is to hypothesize buying a car and suppose at least for the first car to own entirely the purchase capital (as often happens for the first car donated or handed down by parents and relatives). When you become the owner of the vehicle, a precautionary estimate is made of how much it would cost to purchase a higher-class car. Estimated the necessary capital, estimated on the basis of the annual use for how long we want to keep the car and estimated through average prices the value that the car will have at the end of its useful life, we can calculate the depreciation fund and the relative share.

In this case we also give an explanatory example : today I buy a car at a price of 18,000 USD and using it for about 30,000 km a year I suppose to keep it for 5 years. I hypothesize that at the end of the 5 years I will probably want to move to a higher category. The average price of the upper class today is around 22,000 USD. Applying a cautionary price growth I suppose I will need 25,000 USD to buy the new vehicle. Analyzing the market quotations I estimate that my car at the end of the five years will have a commercial value of about 7,000 USD. So 25,000-7,000 = 18,000 USD of capital to be reconstituted in 5 years. Assuming a monthly combination (here that the good self-control of the expenses is fundamental) will be 60 quotas equal to 300 USD / month.

The amortization quota that we have calculated has the enormous advantage of being entirely made up of capital, in fact with this system we will not pay any interest.

But if it is so convenient we should always apply this principle, because in reality it is almost always used to finance?

1) The first reason is not just related to the fact that very often even the first car does not have the initial capital. Therefore, by resorting to financing, it is not possible to simultaneously pay the installment and the amortization rate.

2) The second reason is related to the opportunity cost, that is the lost profit that is determined by immobilizing the initial capital (18,000 USD in our example) entirely in the purchase of the asset.

A very broad discussion could be opened on the opportunity cost, but in this article we will limit ourselves to an example that anticipates something about the concept of financial leverage.

We always assume taking the initial example as a reference, to have the 18,000 USD needed to purchase the vehicle. We therefore have two opportunities:

1) Buy the asset by paying in a lump sum and thus immobilizing the capital for 5 years

2) Invest the capital in a fund or simply by keeping it in the bank and request a loan to purchase the car.

The choice between the two opportunities depends on the ability to obtain a return on capital, ie to invest it by cashing in those who are defined as active interests in the economy. For example, let us assume that the bank is willing to pay us 4% annually on the capital in deposit. In this case, by keeping the money on the account, we would have a gain of 720 USD at the end of the year for a total of 3,600 USD in the 5 years

Having invested the capital in the bank, we have to ask for a loan of 18,000 USD. Let us assume that they offer us 5-year consumer finance with a global effective rate (APR) of 7%. In this case, we would pay a monthly installment of around 357 USD, repaying a capital + interest of around 21,385 USD over the five years, that is, we would pay interest expense of 3,385 USD.

From the data in this example it is clear that investing 18,000 in the bank account would lead to a collection (3,600 USD) higher than the interest that we would pay for the financial (3,385 USD), therefore, in this case it would be better to keep the money on the counter bank and ask for a loan to consumption under the aforementioned conditions.

We observe that a simple comparison of interest rates would lead us to think exactly the opposite: interest income 4% per annum and interest expense 7% monthly. This comparison is misleading for the simple reason that the calculation of the loan repayment interest is made with the French system which provides for a scaled trend of the interests according to the capital returned. Therefore it is essential to keep in mind what is being compared and in cases of uncertainty proceed with the precise calculation of total active interests and total passive interests. Only in this way will you have the certainty of having made the choice following the right financial driver.