How to pay your bills

Here’s another interesting one on interest rates, just for fun:

long-term-interest-rates-us

It looks like interest rates have always been volatile.

To me, if I were an investor, whether that be someone playing the stock market, OR someone with just a savings account, I would keep an eye on interest rates all the time.

I’d keep my money in savings when interest rates were higher than the historical average and in the stock market when it’s below the average interest rate historically. It’s hard to say from this graph but I’m guessing its around 8%? It’s really hard to say because it’s so all over the place.

But…

I would also keep a constant eye on the inflation rate. If the inflation rate is above the interest rate, it would make no sense to save, because my savings would be eaten away by inflation over time, and I should play the stock market. (Source) I should put my money in the stock market because I can get more of a return, on average, around 10%, as a conservative estimate, if I invest there. However, this would only be a good idea if inflation was below 10%. (Source)

If the inflation rate was below the interest rate, I would save my money in account with an interest rate higher than inflation. That way my money would grow in value over time.

At least until the next downturn. That’s why I think it’s important to pay attention to the annual rates of both inflation and interest.

If we take a more up close look, it seems like the current inflation rate is about 2% if you use the current government measurement of inflation rate and 8% if you look at the 1980-based inflation rate measurement, also done by the government.

Inflation

This is controversial because some people say the 1980 measure is more accurate and that the government changed the way it measures inflation in the 90’s, and again in the 00’s, to make the inflation rate look better than it really is in reality.

I like to take the average of the measurements and use that as my yardstick. So my guess is it’s about 5%.

Which sucks because I’ve never seen a savings account, in all my research, that is any higher than 2%, and that was a hard find. I did find, however, that credit unions offer way higher interest rates on savings accounts than commercial banks. (Here’s some credit union checking account APYs that are good) Regardless, 5% inflation is higher than 2% interest, so it makes more sense for me to invest.

Which is exactly what the government wants you to do.

When you invest, the economy grows, when you don’t invest, the economy contracts. GDP is a numbers game and the higher your GDP growth looks, the better the world thinks your economy is doing, the more money you get coming in, the wealthier everybody gets. Everybody wins.

Except savers. Which, some people say that’s where REAL capital should come from. Some say credit and inflation is debt you are paying back on imaginary money that never existed.

My thinking is that people who are saving their money are doing it for things like putting a down payment on a house or going on a vacation. Short term things. I don’t think they are saving their pennies so they can invest in a company they think is going to be big later. That’s why I think savings is not the best way to get capital. I also, however, think that getting capital from credit solely is too risky and why we keep having huge credit bubbles that burst. (The financial crisis of 2007-08, the dot com bubble, etc.)

Here’s some credit bubbles. When there’s a lot of inflation, these get pretty big.

CreditBubbles

Now, since we’ve discovered that it makes more sense for me to invest than save, how do I know that? Well, historically, over a long time horizon, adjusted for inflation, and including all financial crashes and booms, I’m likely to earn 10% return on my investments in the stock market. If the inflation rate is 5%, and my return is 10%, I’m really earning 5% on my investment. Which is better than the -3% I would make on putting my money in a 2% interest earning savings account. If I saved right now, I would actually lose 3% of the value of my money over time.

That’s how I pay my bills.

It works with debt too

I pay off the debt (my student loans) that’s compounding more interest than the inflation rate and hold off paying the debt that is less than the inflation rate. (Source)

For example.

Say I have a student loan with an interest rate of 11.75% (I do) and a student loan with 3% interest (I do). The inflation rate right now is about 5%.

Which one makes more sense to pay off first?

11.75% student loan debt interest MINUS 5% inflation = 6.75% student loan interest.

The real interest rate I’m paying is 6.75%, so I better pay that sucker off as fast as possible, even though inflation is 5%.

Now for the second loan.

3% student loan debt interest MINUS 5% inflation rate = -2% student loan debt interest

Sweet.

My student loan real interest rate is -2%, which means inflation is eating away at my debt by 2% annually. Which means if I pay off my other loan first, and hold off on paying this one, the debt will become smaller and smaller over time and become easier to pay off with my inflated dollars.

This is another example of what I mean.

Say my loan is for $10,000 (haha that would be GREAT). Say I went to school in 1980 and I just decided to make the minimum payment on it until 2016. In 2016 dollars, $10,000 is a lot of money. At least it is to me. And in 1980, let’s pretend that that’s still a lot of money for the example’s sake. Now say I wait until 2016 to pay it off. When using an inflation calculator, suddenly my debt is worth only $3,460, which I can pay off much easier than $10,000.

But. Pretend inflation goes down.

My loan is still for $10,000, but in 2016. And inflation goes down, or we experience deflation in the negative numbers. Something like that. Then, in 2036, after the deflation, my loan is now worth $13,500! That’s MORE debt I owe than when I first got the loan!

That’s why it’s risky, but you could pay down your debt when inflation is below your interest rate, and you would be better off investing your money, and paying off your debt with the invested money in the future.

For example.

You could take the $200/month you would have paid down your debt with that has a 3% interest rate and put it in an investment portfolio. Then, as long as the inflation rate stays above 3% for 20 years, you take your 10% returned investment money, and pay off your loan with it. So in actuality, even though you just paid down your loan, you still earned 10%-3% = 7% long term.

Economics is pretty cool, huh?

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s