What Problem Does Infinite Banking Solve?
Rate vs. Volume
To understand the problem, we have to resolve an astonishingly pervasive myth in the financial world. It’s the idea that interest rates on loans matter. How could interest rates not matter?! Let’s use the example of housing with the following information:
Purchase price: $200,000
Interest rate: 4.5%
Mortgage repayment term: 30 years
This information gives us the following graph.
Notice that the monthly payment comes out to $1,013.37. Multiply that by 12 and then by 30 (for 360 months of payments) and we arrive at $364,814 in total payments. You can use these calculators to input your own information. In the example above, notice that the stated interest rate of 4.5% appears to have little to nothing to do with the actual amount of interest paid.
If, instead of looking at the interest rate on this loan, we looked at the volume paid out, we get an entirely different picture. Take the total volume of interest paid over the course of these 30 years $164,814 and divide by the total payments $364,814. This gives you interest by volume of 45.17%. This is a much more accurate representation of the ratio of dollars flowing out of your control — the true cost of the loan. In other words, at the end of the term, this individual would have paid $164,814 in order to build $200,000 in equity in the home (assuming the value of the house doesn’t change).
Not only is the $164,814 lost to the lender, but we should also account for the opportunity cost. The opportunity cost of this money is whatever you could have done with it otherwise. Who knows what that number is. And of course, it will be different for everyone, since different people can use a given dollar to earn various levels of return. Regardless, it is something. It’s greater than zero. It’s probably a lot greater than zero. Whatever that opportunity cost is, if it’s greater than $164,814, that is the relevant loss.
The problem of interest rates vs. volume is especially bad in the mortgage industry, but the problem pervades in any credit transaction with a third-party lender where there is a stated interest rate and a stated term of repayment. The point is that the interest and fees lost to conventional lenders are enormous.
It’s Not (Just) about the Money
The interest and fees lost to third-party lenders are not the most significant costs of dependency on conventional lending. Other costs take the form of:
Lengthy, time-consuming applications
Restrictions on the use of borrowed funds
Selection requirements (e.g. credit score thresholds)
Physical collateral assignments (i.e. “if you don’t pay, we take your stuff”)
Mandatory repayment schedules (i.e. reduction in control of future cash flow)
Hostile bill collections personnel
Reliance on personal relationships with lending personnel
Callability provisions (i.e. the risk of a bank calling your loan due)
All of these are non-monetary costs. The issue is that the effective monetary-equivalent prices of these costs will vary. If a recession hits, your bank is bought out, and the institution that acquired your loan calls your loan due, this may result in significant financial strain. It may mean you no longer have the necessary liquidity to operate your business. This — unexpected loss of liquidity — by the way, is the single greatest cause of business failure in economic downturns, which tend to happen every 5–10 years (thanks to the problem of fractional reserve banking).
What is the price of the risk associated with the loss of one’s business due to the lack of control over capital? I don’t know. But it is a risk, and risk does bear a cost. The individual borrower always bears the risk associated with accessing capital. The point is, this particular example of a non-monetary cost of dependency on third-party capital is something and it should be accounted for in considering the cost of access to money.
Other examples pervade. In general, the unexpected is a tremendous source of potential cost (unexpected medical events, loss of employment due to unforeseen layoffs, etc.). However, the unexpected is also a tremendous source of potential opportunity. Unique investment and entrepreneurial opportunities occasionally come our way. What’s necessary, though, is control over a sufficiently high level of resources in order to take advantage of it. If an investment opportunity comes your way, but you don’t control enough capital to take advantage of it, then it might as well not have been an opportunity in the first place. The point is that there is an additional cost to financial unpreparedness. In particular, that cost is the present value of the future earnings that a given investment opportunity would have earned for you. What’s that number? I don’t know. But it’s greater than zero — potentially a lot greater than zero.
It’s All about Capital
The problem that the Infinite Banking Concept solves is the fact that the average American is severally under-capitalized. It’s death-by-1000 cuts due to exposure to the costs (monetary and non-monetary) of dependency on third-party capital, and it’s a world of opportunity lost due to the lack of financial resources necessary to seize her when she comes.
This is the problem that the financial advisory community should be most concerned with. Most in that community are not. They are consumed with optimal portfolio allocation — a subject of investment strategy. Little to no attention is paid whatsoever to the dramatic costs of dependency on third-party capital nor to the opportunities lost due to (severe) under-capitalization. Unfortunately, the proposed investment strategies often leave individuals with control of even less financial value. After all, the whole point of investing is to give up control of financial value in order to generate an (expected) return. This leaves the individual maximally exposed to the costs of dependency on third-party capital and maximally unprepared to take advantage of opportunities.
I continue the discussion about the importance of capital here. For a very brief overview of how the Infinite Banking Concept works, go here. A future blog will discuss why the Infinite Banking Concept is objectively optimal for accumulating and deploying capital.
Have a great week!