The Net Present Value – NPV

This function is similar to IRR but calculates the equivalent present value of a range of future cash flows, given an interest rate.  In other words, what would all those cashflows be worth today assuming a required IRR if you had a single lump sum instead, replacing the future streams of incomes and outgoings. 

If the cashflow schedule is the same one as that used for calculating the IRR, and the IRR is used as the interest rate in NPV, the NPV will be exactly zero.

One can compare and evaluate different cash flows by comparing their Net Present Values.  In some ways, the NPV as a cash lump sum is easier to visualise, and is particularly useful when evaluating the costs of switching mortgages as you must do before making a re-mortgage decision.  It can be likened to a cashback calculation.  But you must be careful to use the correct, relevant interest rate assumption.

Some examples of the NPV in action are shown in the “Loan Comparator” spreadsheet and in Part II.  But as another example, lets us look at the same two schemes described above when comparing IRRs and APRs.

The results in the table below show that scheme B is better value over six years because the IRR is lower as before, despite the APR being higher.

But the NPV of scheme A over six years compared to scheme B is £1,100.  This means that if there was a cashback of £1,100 with scheme A, the IRR would then be identical to scheme B.  Alternatively, if there was an additional lump sum fee of £1,105 on scheme B, (ie a negative cashback) it would equate to the IRR for scheme A.

So you can visualise scheme A being around £1,100 more expensive – an easier figure to imagine than the IRR difference.  Another way of looking at the comparison is that you would need a monthly payment reduction of £18.51 for the six years with scheme A to make it comparable:  this monthly alternative is also shown on the spreadsheet.

Accuracy warning

And now some words of caution.  Any future interest rates data that you enter in these calculators, such as the “Loan Comparator”, are usually merely a guess as to what those rates will be in practise.  In real life, interest rates are hard to predict; in fact impossible over a long period unless fixed at outset.  Any comparison tool is only as good as the guesses made for the relevant variables. 

Fortunately, in most cases, while the actual numbers, such as the IRR, may turn out to have been inaccurate in practise, the comparisons might well remain valid.  In other words, if future rates turn out to be higher or lower than predicted, the effect should be fairly consistent on the comparisons if the margins remain consistent, so the value-for-money ranking should therefore not change.

Where this may not be true is with loans with an initial fixed rate, changing to a variable rate later, when comparisons include both rates within the term range of a calculation.  A different variable rate guess can then easily change the value-for-money order. 

Margin lock or linked rates

Some newly launched lenders offer initially attractively low variable rates and incentives just to get established, but may then increase their margins later on, once they have grown large enough and become established.  Once a product has been bought, borrowers soon become complacent, and seldom re-check the validity of their first decision and seldom notice widening margins.

This somewhat cynical observation tends to apply to many new product launches, which is done in order to attract public and media interest.  The exception is with products where the interest rate is specifically linked (usually by a fixed margin) to an independent base rate, such as Bank of England Base Rate, or LIBOR, the London InterBank Offered Rate. With such linked rates, the lender’s margin is effectively locked in throughout the loan, so whatever happens in future, the interest rate formula will always remain the same.

For example, a lender might advertise a rate that is always a fixed 1.5% above 3 month LIBOR.  You can look up this rate in the newspapers as it is independently set.  The only downside is that your payment will then alter every time the linked rate changes, which could also be every three months.  On the other hand, the lender is then committed to that margin.  This might seem attractive but new digital technology is constantly reducing the lender’s administration costs. It could well turn out that some lender in future might offer an even lower margin.

In summary, although the calculation results are themselves very accurate, real life may turn out to be different. Market forces may eventually lower the projected variable rates, which, at worse, could invalidate your analysis of the best-buy. You can minimise this happening by trying a range of guesses before finally making up your mind. Life wasn’t meant to be too easy.