Loan efficiency refers to how much cash a particular loan takes out of your monthly budget. Some loans are relative Hogs while others are relative Hummingbirds. It is best to have flexibility in your financial life, and having loans with high efficiency enables this over low-efficiency loans. You can usually make extra payments on a loan to pay down the principal balance sooner. However, the loan Hogs require you to do this and the loan Hummingbirds do not. Your financial position may change and having flexibility is helpful.
Let’s examine a scenario, let’s say you need a $10,000 loan. You could get a 4-year installment loan (with an interest rate of 8%) and your monthly loan payment would be $244. Or, you could get a line of credit (with an interest rate of 8%) and your only monthly payment would be just the interest of 8%, or $66. In this scenario, the $66 payment would be the Hummingbird and the $244 payment would be the Hog.
For loan efficiency, in general:
- The longer the term, the higher the efficiency
- The lower the rate, the higher the efficiency
The objective way to categorize your loans (and potential loans) is to divide the outstanding balance by the monthly payment. This equalizes and indexes each loan to a single discrete number. This allows you to rank and compare alternative funding, payoff , and re-financing possibilities. The higher the ratio, the higher the loan efficiency. Likewise, the lower the number the lower the loan efficiency.
Similarly, investments can also be ranked for efficiency, the criteria is just flipped upside down. Again, monthly payments to you is better than quarterly or annual payments. You can rank investments with similar risk by their payment efficiency. Unfortunately, you need a financial calculator that includes compounding, called ‘discounted cash flow.’ For example, if you are paid monthly, you have that cash that can earn a little more money for you by reinvesting it, rather than one payment at the end of the year. An online calculator can perform these discounted cash flow calculations for comparison: https://www.calculatorsoup.com/calculators/financial/present-value-cash-flows-calculator.php
Whether you are borrowing money or making investments, you want to replace inefficiency with efficiency, and these calculations reveal exactly how to rank your options. So, if you’re on a debt-reduction plan, start paying down the low-efficiency Hog loans first. Or if you’re trying to increase your investment income, move your money into higher discounted-cash-flow investments.