Buy or Borrow?

EASY MONEY>MONEY MATH

Buy or Borrow?

Nelson is thinking of building a new house worth P5 million for his growing family. He and his wife Clara have accumulated savings of around P4 million. Given their aggressive investment style, they have generated an average rate of return of 15% for the last 10 years. Although there’s an ongoing economic slowdown, they figure they can still achieve the 15% average return for the next 10 to 20 years.

Now, he is seriously considering withdrawing all their investments and use the proceeds to pay for most of the costs, financing the remaining million. Clara thinks it’s a bad idea, and would rather get a bank loan and use the income from their investments to pay the amortizations. Mortgage rates average 11.5% fixed for 20 years. The bank is willing to finance the entire project since the appraisal of the house plus the lot (which they already own) already exceeds P5 million. To compromise, Nelson suggests they use half of their savings instead. What is the best move?

  1. Use all their savings to pay for most of the construction.
  2. Finance the entire construction cost and continue to invest their entire P4 million.
  3. Use half of their savings as equity, invest the other half, and borrow the remaining P3 million.

Answer: B

It usually pays off to just borrow if you can invest your savings at a higher return than the cost of borrowing. In this case, even if their savings is just P4 million versus the P5 million total construction cost, earning 15% on the P4 million can generate annual income of P600 thousand, still enough to pay for the annual amortization of around P533 thousand, a positive net cash flow. Using half of their savings and investing the other half (or using all their savings) will result in negative cash flow. The compromise is the second best choice because even if there’s a little negative cash flow, they will still end with a positive ending cash balance after 20 years, primarily because they’ve kept half of their savings intact. So yes, cash is king.

One thought on “Buy or Borrow?

  • October 6, 2010 at 11:23 pm
    Permalink

    a 15% annual return on invested capital is impressive, more so that they are able to do this the past 10 years. I am in somewhat similar situation as item 2 , but have chosen to repay the loan principal gradually at the expense of additional investments as this will reduce my monthly amort.
    By paying the Housing loan I have a guaranteed a return of 9.5% (the bank interest rate).

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