Home' Trinidad and Tobago Guardian : January 17th 2016 Contents The case
illian, single at age 41, is a super-
visor earning $10,500 monthly
before taxes. She has been dream-
ing of owning a home for over a
decade but is nowhere close to
making a downpayment. Over the
years she has focused all of her savings in a
share account at her company s credit union.
The credit union has a rare habit of consistently
paying one of the highest dividends rates in
the industry, never below five per cent per
annum. Because of these superior returns, Jil-
lian frequently invests any windfalls she receives
in her share account. However, her problem
is she is always at the 2:1 ratio of loan to shares
with her debt currently at $150,000.
One of Jillian s new year s resolutions is to
clear off her debt as fast as possible so she
can reclaim her savings and make that down-
payment on her house. She is treading carefully
because there is always the temptation to say
yes to a no-hassle one per cent loan sale.
Two friends at the office are arguing which
is the best strategy for Jillian to pursue to
become debt free.
Sarah said she cleared off her debt faster
by diverting her monthly share contributions
directly to her loan balance. Jillian currently
contributes $500 to shares and $3,500 to the
loan. Melanie, on the other hand, advised
Jillian to bite the bullet and approach her bank
for an unsecured facility and just clear off the
difference between her shares and loan balance;
then have the credit union offset the residual
debt with the shares. Sarah counters that the
bank will charge a very high interest rate,
which is sometimes three per cent or more
than the credit union and thinks Jillian should
think twice about doing that.
Jillian is very confused as to which is best
suggestion and is thinking to play it safe and
let things stay as they are.
Every financial institution has its strengths
that could benefit customers in different ways
but, the thought that one size---or rather one
instrument---fits all is sometimes a recipe for
This thinking also applies to financial strate-
gies. While each friend may have had success
with their individual approach, their circum-
stances may have been drastically different
and might not apply to Jillian. Jillian has to
consider fact rather than feelings when choos-
ing which route to take.
Jillian is no different from many who decide
to place all of their savings in the highly attrac-
tive credit union share account, especially
when it consistently pays dividends of five
per cent or more per annum. The flaw with
this strategy is that no money is allocated to
handle short-term financial needs such as
emergencies or unexpected bills. In the end,
the only way to access these funds is to take
out a loan.
Reducing balance loans
The unsuspecting investor/borrower can
easily misinterpret the advertised one per cent-
rate to mean the annualised interest rate. This
rate is, in fact, only a monthly rate on the
reducing balance basis. This really translates
into a yearly 12 peer cent interest rate. The
investor/borrower could erroneously assume
their savings are earning $5 on every $100
invested and they are paying only $1 on every
$100 borrowed, giving them a profit of $4.
The reality is they will actually pay $1 for
each month that the $100 debt remains out-
standing, translating to $12 a year while the
dividend is only $5 per year; resulting in a $7-
loss ($5 - $12). Another misunderstanding is
that the reducing balance feature is unique
only to these loans. The truth is all loans have
balances that reduce after the monthly or peri-
odic interest is calculated and taken out of
the installment---banks and credit unions alike.
Weighted average APR
(annualised percentage rate)
Even though Jillian s loan attracts interest
at 12 per cent per annum, the overall average
interest rate is lower because of the effect of
the dividend rate of five per cent per annum,
which subsidises the cost of funds on the loan.
Half of the loan is unsecured and shares secure
the other half, so the overall effective weighted
average interest rate of the loan works out to
about 10 per cent per annum.
Size of debt matters
Having dividends offset the cost of funds
on the loan is a real advantage but, at the end
of the day, Jillian should be more concerned
about the total amount of dollars she puts out
in actual interest costs. Paying more money
in interest means pushing her goals further
into the future. For this reason, simply paying
off the loan sooner is not sufficient. She must
do so in the fastest and most cost-effective
way possible. To do this, we have to look at
the impact of the level of her borrowings.
Having an effective interest rate of 10 per
cent per annum on a loan of $150,000 may
not necessarily be cheaper than a 15 per cent
(12% + 3%) loan of $75,000. Even though the
potential cost of funds on the unsecured bank
loan is significantly higher, because of the rel-
atively smaller debt it might actually cost less
at the end of the day.
The no-action strategy
If Jillian decides to let things run as they
have and make a concerted effort to arrest
further borrowing, she would pay off the loan
in 56 months. The interest cost will be $46,843
and she will continue to add $500 to the share
account, which earns five per cent in dividends.
In a little less than five years, the share balance
would have grown to $126,374.
Sarah suggested that Jillian redirect the share
contribution of $500 to accelerate her pay off
date. Doing this will make her debt free in 47
months. In that time, the total interest cost
will be $38,940. She will still earn dividends
on her shares and, in a little less than four
years, her share balance would have grown to
Melanie wants Jillian to approach the bank
for a $75,000 unsecured loan paying the same
$4,000 per month at 15 per cent APR. She
will use her shares to offset the remaining
balance of $75,000 on the credit union loan.
This bank loan will be repaid in 26 months.
In that time, the total interest cost will be
She will have absolutely no savings to use
for emergencies but this is not much different
from the other two strategies because the sav-
ings are inaccessible as long as the loan is out-
standing. If she has an emergency, she will do
what she always does: borrow. But, the level
of debt will not be as high with Melanie s
For a meaningful comparison, we have kept
the timelines the same for Sarah and Melanie s
strategies (47 months). As soon as she pays
off the loan, Jillian can then invest the $4,000
in shares for 21 months at the rate of five per
cent per annum.
At the end of the investing period, Jillian s
share account will have $108,431.
The final analysis
At the end of 47 months, using Melanie s
strategy, Jillian would have paid $27,947 less
interest on her debt and saved $17,155 more
in shares than if she had followed Sarah s
D C F fi
F C C y y
JANUARY 17 • 2016 www.guardian.co.tt SUNDAY BUSINESS GUARDIAN
FINANCIAL ROAD MAP | SBG7
Dealing with debt
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