Let’s use an example to demonstrate this. Keith’s grandfather passes away and Keith finds himself the beneficiary of a $250,000 inheritance—his grandpa was an immigrant who worked himself to the bone and saved every cent he ever earned. To honour his grandfather’s legacy, Keith decides to use the money responsibly, rather than blowing it all on a German sports car and similar accoutrements of a mid-life crisis.
Keith decides that the best thing he can do is pay down his home loan. Keith owes $400,000 and after making a $250,000 contribution, he has brought the balance down to $150,000. By doing so, he has significantly reduced how long it will take to pay off the loan, thereby reducing the amount of interest he’ll pay over the life of the loan.
But there’s another way.
Let’s imagine a second scenario where Keith invests that $250,000 for three years at a rate of 12 percent per annum, so 36 percent in total. After three years, Keith now has $340,000. He takes the $90,000 that his investment generated and puts that towards his home loan, and re-invests the $250,000 again. For the sake of simplicity, let’s assume it’s the exact same duration and rate of return: 36 percent over three years.
After six years, Keith has contributed $180,000 towards his home loan, but he still has the original $250,000 which he inherited, so his overall financial position is much stronger. Keith can repeat this process over and over again until his home loan is paid out and he is debt-free with a $250,000 nest egg which he can continue to grow.
| Year | Home Loan remaining |
|---|---|
| 1 | $400,000.00 |
| 4 | $310,000.00 |
| 7 | $220,000.00 |
| 10 | $130,000.00 |
| 13 | $40,000.00 |
| 16 | -$50,000.00 |
This is a very basic example. There are many factors in Keith’s life which are not accounted for, such as interest rate changes over time. But it demonstrates the importance of having an investment strategy. Many people’s financial education from their family or school doesn’t extend any further than “savings good, debt bad”.
Saving your money is a simple way to be financially responsible, but it might not necessarily be the best thing you can do. What Keith’s grandfather didn’t understand is that your money should be working for you, not the other way around.
