What’s Your Real Interest Rate?

As an accountant, I work with financial statements every day.

I spend a lot of time reviewing P&L’s and balance sheets. And when I signed up for Mint and connected all my accounts, I was pleased (nerdy, I know) to find a sort of “personal balance sheet” which is really the software showing your Net Worth figure.

If you use Mint, Personal Capital, or a similar software, or if you are simply doing the calculations by hand, you’ll generally see some of the same types of accounts involved in your Net Worth calculation.

Traditional bank accounts such as savings, checking, maybe a CD or something similar. Then you’ll see credit cards, loans such as a mortgage or student debt, investment accounts, and any property (such as cars, houses, or buildings) which may be associated with the loan balances.

Essentially, you’re looking at how much your accounts and possessions are worth, versus how much money you owe to other people.

The net amount of all these numbers, in accounting parlance, would be your personal equity. But most would refer to it simply as your Net Worth.

In Mint or other budgeting software, you can drill down into your investment accounts and see an analysis of the growth of your holdings over custom time periods, and likely be shown your “rate of return” for each or a combination of all your investment accounts.

Often you may also see how these figures compare to the performance of an index such as the S&P 500 over the same time period(s).

Net worth. Rate of return. Pretty straightforward and familiar.

What may not be familiar, however, is the concept of your “real interest rate,” something I call Net Interest Rate. 

You probably have a good idea of the ROI for your retirement accounts or other investments, but do you know to what extent those gains are being offset by separate interest expense?

If you have a mortgage, a car payment, student loans, credit card debt, or all of the above (like me), then it may be worth your time to run the numbers for yourself.

Keep in mind that these are cash flows from your assets and liabilities, and have (mostly) nothing to do with your regular income and expenses.The principal portion of your monthly mortgage or car payment is actually being transferred from a liability to an asset, and thus doesn’t “cost” you anything in this calculation. I’m simply talking about interest here.

Here’s an example of calculating your real interest rate:

Account  Balance  APR/ROI Annualized
Checking Account  $        7,000.00 1.25%  $         87.50
Savings Account  $        2,000.00 0.02%  $            0.40
401k  $        5,000.00 8.00%  $       400.00
IRA  $      35,000.00 8.00%  $   2,800.00
Roth IRA  $        3,000.00 8.00%  $       240.00
Car  $      19,500.00 -5.00%  $     (975.00)
House  $    157,000.00 3.20%  $   5,024.00
Mortgage  $ (130,000.00) -3.50%  $ (4,550.00)
Auto Loan  $    (16,000.00) -3.99%  $     (638.40)
Student Loans  $    (13,000.00) -4.80%  $     (624.00)
Credit Card  $      (2,500.00) -12%  $      (300.00)
Net  $      67,000.00 2.19%  $   1,464.50

Here I’ve listed hypothetical bank, investment, credit card, and loan accounts, along with property in the form of a residence and car. Each account shows the balance as either an asset or liability (+/-), as well as the annualized interest rate or rate of return, as applicable.

For example, the house’s property value is forecasted to rise by 3.2% over the next few years (based on Zillow or similar tool), while the interest rate on the mortgage associated with the house is fixed at 3.5% APR.

(As an aside, notice how both the “asset” value of the car and the loan associated with the car show a negative “APR.” Always remember that vehicles are depreciating assets, so any loan against a vehicle is essentially paying for the privilege of owning something that loses value by the day. No judgment here, I financed a car myself; just something interesting to think about!)

The last column shows the annualized “cash flows” generated by each of these items based on their interest or return rates, showing us how much money they are costing us, or generating for us, respectively.

This example is pretty close to what I saw the first time I did this exercise. While I don’t remember my exact “real return” at the time (2.19%, in this case), I remember seeing how it was a fraction of what I generally considered to be the performance of my money.

I’m sure many of you would default to the same line of thinking, because we typically only consider and evaluate performance metrics on our investments, or the market in general (up 12% this year, etc.).

But how much of your money is actually subject to market returns, versus the amounts that you’ve borrowed and are paying somebody else for?

It is easy to see how a typical consumer could easily have a net negative annual interest rate as well.

Most of the positive returns in this example come in the form of mid 5-figure investment balances and a little bit of equity in a home. If you are early in your career or don’t have much saved up yet, it’s reasonable to think you have a negative overall rate of return if you have any level of student or consumer debt.

Another important takeaway here is the volatile nature of the positive rates versus the fixed nature of the negatives.

Know somebody who bought a home in Phoenix in 2007? Ask them about 3.2% property value growth. Similarly, in some years your investment returns will be above this 8% assumption, and in others your investments will cost you money.

On the flip side, the rates on the mortgage, auto loan, student debt, and credit cards will never change, assuming you don’t refinance or declare bankruptcy.

This is important to remember when taking on additional debt –  your investments, your pay rate, and your property value will rise and fall many times before you’ve conquered the constant expense of debt payments.

What do you think? Do you have a positive real interest rate? If you do the exercise with historical numbers, has your rate improved or gotten worse over time?