First of all I must admit that I can’t take credit for this concept. This concept was originally developed by Nelson Nash in his book “Be Your Own Banker” (which you can find here). So I would like to give credit where credit is due.
Having said that, I find some wonderful correlations between what we do here at PaleoSaver and Nelson’s concepts. So I would like to discuss those ideas and how to start them. For the purposes of this blog post I will primarily be introducing the concepts, there will be more information in the future about the details. I would just like to get a big picture overview here.
I like to call the concept Self Financing. It has been called Being your own Banker, and Bank on Yourself among other things. Essentially however the idea is to borrow from your own pool of resources rather than borrow from someone else, especially a bank. So I think “Self Financing” is a great descriptive term that helps get across the concept. There are some great advantages of self financing over borrowing. Here are a few:
Recapture Interest – When you borrow from someone else, often called OPM (Other People’s Money), the single greatest disadvantage is not that you have to pay the money back but that you have to pay it back at interest. The interest is owed to the lender because they have now lost the use of those funds because they lent it to you. Rightly so, they have lost the opportunities that might have come if they kept rather than lent the money. So to compensate the lender for their opportunity costs you pay them an interest rate. They value the interest later more than the money now and you value the money now more than the interest later so win/win. Don’t misunderstand I am not making an argument against lending and borrowing, I am simply saying that you should be lending and borrowing from your own accounts rather then from someone else. The main reason, to recover the interest. When you borrow from someone else you pay them the interest as we have established and justifiably so. You will never see those interest payments again, they are lost to you. Gone forever. However if you borrow from your own resources you will be paying back your own accounts at interest and you are recovering the interest payments. Put in simpler but less exact terms you are paying yourself back at interest. You might ask “why should I pay myself interest on money I borrow from myself?” For the same reason you would pay someone else interest, opportunity costs. Opportunity costs are very real, but invisible. We don’t see them because they never materialize. Opportunity costs are the things we could have had or done if we had not done what we did. So for example if I bought a car that means I cannot also buy a boat with those same dollars. Money used on one thing cannot also be used on something else. Pretty simple really. So when you borrow from someone else then they have opportunity costs they need to be compensated for with interest, and when you borrow from yourself you have opportunity costs that you need to consider as well. To compensate yourself for opportunity costs treat yourself at least as well as you would the other guy. Don’t cheat yourself. You wouldn’t try to cheat someone else out of what you owe them, so don’t treat yourself any less. When you look at it this way, you should realize that paying yourself back at interest beats borrowing every day of the week since you will recover the interest payments your making rather then lose them forever.
Re-Use of Money – This is what banks and other “churn” businesses do and the real secret to their profits. They re-use the same dollars over and over to add more dollars to their balances and then churn those over and over to add more and rinse and repeat. If your in any kind of a business that involves inventory you understand that if your not turning over your inventory again and again your not making money. Well thing of dollar bills as inventory, bankers certainly do. Their “product” is the notes themselves. They want to churn these notes as many times as they can and continue to do so over and over. This is the secret to their high profitability combined with their fractional reserve nature. We won’t get into fractional reserves here, but you can do the same thing with your own money. Getting to use the same dollars again for something else is a two for one deal that just can’t be passed up. Let’s say you have an account of some kind with $100,000 of value. You borrow $25,000 to buy a car. Over five years you pay your account back, with interest, at the end of that you now have all of your money back with interest and you have the car. That’s a win. You can now use those same dollars over again for something else or for a car for another member of the family who might need one, and repeat the process. Be sure that you have the income to pay back to your account just as if you were making car payments, and you have recovered every dollar with no opportunity costs and you have the asset you bought. Not a bad situation to be in.
In order to do this you have to have an accumulation phase. This can take anywhere from five to 10 years depending on the variables, but once you have accumulated the funds for your purposes you don’t need to keep contributing to that particular account. You can start another, or do something else to continue your savings. The point here is that you need to accumulate funds first in order to be able to borrow against them. That makes sense of course, and is the biggest reason why so many people do not utilize this approach. It requires budgetary discipline and long term thinking. However if you can live within a budget that allows you to save at least 10% of your income regularly into a safe account of some kind then you probably can benefit.
So what vehicles are used for Self Financing?
401k – You can borrow against your own 401k. While this still beats using a credit card, for example, it is not the ideal vehicle for self financing for a few reasons. First of all the money in your 401k is most likely tied to the stock market, and the volatility of those assets do not lend themselves well to a self financing plan. The amount of money available will fluctuate too wildly to be a reliable pool of resources when the need arises. Also, when you borrow against your 401k you are actually selling some of the underlying assets in order to fund the loan. While you will be paying back at interest, there is no way to predict the opportunity costs your trying to compensate for due to the volatility of the market. If the market skyrockets you could have lost out on a great opportunity if you had just left the money in there. You would not be able to afford the interest rate to compensate for that. You lose on the compounding effect of your account which is what a 401k is all about, even though it often fails at that goal, but that’s another article. Lastly there are fees to borrow against your 401k. You don’t get these back they go to the administrator of your account. So while it is possible to borrow against your 401k, it’s not the first choice and probably not recommended in most situations. If you have a credit card with 20% interest rates that might be one situation that justifies it, better to pay your 401k back then the credit card company at 20%, but otherwise this is not an ideal option.
Bank – This of course is the traditional and still the most popular option for saving up money to self finance something. A Money Market account or Certificate of Deposit at the bank is what people commonly think of as a savings account. There are a few of disadvantages though. The first major disadvantage these days is of course what banks are paying their depositors these days. 1% at the high end is a miserable rate of interest and will make it very difficult to accumulate the funds. It is a stable rate of return which is good, but it is so low as to be negative after you figure inflation and taxes. So your actually losing money in a bank account these days, not what were trying to do. The other major disadvantage is that, like the 401k, you lose whatever interest or growth you were making when you withdraw to self finance. This makes sense of course, if you take money out of the account those dollars are no longer earning interest in the account. That is the opportunity costs we talked about earlier and why you should pay yourself back with interest. But what if there was a way to have your cake and eat it too? Turns out, there is.
Whole Life – If you have a participating whole life insurance policy you may have one of the best vehicles there is for self financing. Here is why. First interest rates and dividends paid in whole life policies typically are quite higher then interest paid by a bank. Guardian Life for example declared a dividend of 6.1% for 2015. That is six times what you might find at the best of the banks as of this writing. So the rates of return are better. Another great advantage is that those dividends are paid even when you borrow against the policy. Say What? That’s right unlike anything else I am aware of you can borrow from your own policy and still have the dividends calculated as if no money was withdrawn at all. How is this possible? Well simply because the insurance company draws from their overall pool of money to lend to you when you borrow, they don’t actually take funds out of your account itself. This is what insurance companies do, the pool risk by pooling funds together into one big pot from which payments can be made under certain circumstances. Unlike a bank the insurance company actually has the funds they say they have as well. In order to do this properly you need a whole life policy from a mutual company that is non-direct recognition. So it’s important to work with someone familiar with the process who can structure this properly.
There you go. Self Financing is a great way to keep from paying interest to the banks ever again.