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A loan in your budget and in your net worth

Repaying a loan is not spending. Part of the payment leaves your account without leaving your net worth, and confusing the two distorts everything else.

The payment reads two ways

When you repay a loan, the same sum tells two different stories depending on where you look at it.

In your budget, the whole payment counts. The bank takes all of it, interest included, and that money is no longer available for anything else. Counting only the interest means believing you are more comfortable than you are at the end of the month.

In your net worth, only the interest makes you poorer. The principal does not vanish: it moves from your account to your debt, which falls by the same amount. You have less money and less debt, and the two cancel out exactly.

Hence a sentence that sounds contradictory and is not: repaying a loan weighs heavily on your budget and almost not at all on your net worth.

An example

A loan of 150,000 over twenty years at a fixed 4% — the currency does not matter, the proportions are the same. The monthly payment is about 909.

In the first month, 500 goes to interest and 409 to principal. Your budget records an outflow of 909. Your net worth falls by only 500.

Ten years later, for that same payment of 909, interest is down to 299 and principal is up to 610. The payment has not moved, but what it actually costs you has nearly halved.

Over twenty years you will have paid about 218,000 for a loan of 150,000. The 68,000 difference is the cost of the loan. The rest, you repaid to yourself.

What the asset really returned: inflation out, interest counted

This is the other half of the calculation, and the half people forget.

An asset gaining 3% a year while prices rise 3% a year has returned nothing. Its value in money went up, what it buys did not. Before celebrating a gain, take the period's inflation out of it.

Back to the example. The asset bought at 150,000 is worth 200,000 ten years later: a headline gain of 50,000. But if prices rose 30%, it would take 195,000 today to be worth what 150,000 was worth ten years ago. The real gain is not 50,000, it is 5,000.

Then comes the cost of the loan. Over those ten years you will have paid about 109,000, of which 60,000 was principal and 49,000 interest. Those 49,000 are a sum of payments spread over ten years, each in the money of its day: they weighed a little less year after year, since prices rose while the payment stayed fixed. The raw figure therefore overstates the real effort, and that is the one place where inflation works in the borrower's favour. Even so, 5,000 of real gain against 49,000 of interest gives the order of magnitude.

None of this says the operation was bad, and the example is in fact the extreme case: the whole price is borrowed, so the interest is at its maximum. A home spares you a rent, a rented asset produces income, a down payment changes the return on what you actually put in. But those two corrections — take out inflation, count the interest — are made in every case, before any conclusion.

Common mistakes

• Counting only the interest in the budget: the bank takes the whole payment.
• Counting the whole payment as a loss: the principal stays with you.
• Forgetting insurance and fees, which are a pure cost just like interest.
• Rewriting past payments when the rate changes: they happened at the old rate.
• Celebrating a gain in money terms without taking out the period's inflation.

In My Wealth Book

A monthly payment sits on a single line, with its principal, its interest and its rate, linked and editable. Changing the rate never rewrites payments already made: they happened at the old rate, and a history that rewrites itself is no longer a history.

The whole payment goes into the budget, because that is what leaves the account. Net worth keeps only what actually makes you poorer.