Should I Pay Back my Loans Early or Invest? Introduction to Guaranteed Returns and Risk Premium. Part Three.

Should I Pay Back my Loans Early or Invest? Introduction to Guaranteed Returns and Risk Premium. Part Three.

Introduction to Guaranteed Returns and Risk Premium 

This is part three of this blog post series. You should really start from the beginning to get a good feel for the topic.

Link to the rest blog series:

 

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Ancient authors like Aesop, seemed to have a thing about birds.

I can see why. Birds are so much cooler than anything else. Birds are obviously on to something… They fly south in winter while we freeze.

All sorts of bird related wisdom that abounds- “Don’t count your chickens before they hatch”, “Don’t keep all your eggs in one basket”, “Don’t kill the goose that lays the golden eggs”,” Birds of a feather flock together” and “Kill two birds with one stone”.

 

 

My favorite is, “One bird in the hand is worth two in the bush.”

Why is a “hand-bird” worth two “bush-birds”? Because the hand-bird is a sure thing.

To catch the two birds in the bush, you’d need to release your hand-bird to wield the bow or net or whatever. You have just assumed risk or invested. You could easily release the hand-bird and accidentally scare off the bush-birds and end up with zero. For taking that risk you need greater reward, premium, or yield.

Let’s think about the “hand-bird vs. bush-bird” statement in economic terms.

If someone said to you, “I can offer you 2.75 bush-birds for a hand-bird” you’d jump on it. Cause, that’s better than the typical 2:1 market value. You could even go into business trading bush-birds for hand-birds based on your knowledge of roosting habits! Maybe you can offer 4.2 future bush-birds for this season’s hand-birds.

This interchangeable value- the equation goes both ways- gives you an idea of the value of one investment vs. another.

 

 

The difference in yield or return due to assumption of more or less risk comparing one investment type to another is called the “risk premium”.

The risk premium of hand-birds to bush-birds is 1:2 or 100%. You’d need to double your return to consider investing your hard-earned hand-birds in the risky bush-bird market.

If you traded in stocks rather than birds, it would be called the “equity risk premium”

 

Since we know the return of various investments, we can calculate with reasonable accuracy the relative risk premium.

For instance, the risk premium for stocks, at 8% return compared to cash at 0% return gives you a risk premium of 8%. Note that inflation affects both equally and can be removed from the equation. You’ll need to figure the effect of taxes on your own. The “premium” you earn for assuming the risk of stocks rather than cash is 8%.

Editor: Determining the Equity risk premium at the level of a financier is quite complex and controversial. Which stocks index do you use? What comparator do you use? How do you take volatility into account? This is all great stuff. But It’s not required for our straightforward purpose and will be glossed over for this post. We’ll just use a historical average for a good enough ballpark amount. If this stuff fascinates you, there’s some good online resources that can be found with a simple google search.

 

 

Using the Equity Risk Premium to Determine Loan Payback vs Investing.

When you take on a loan (I’ll use a mortgage as the main example, but it applies to nearly all loans), you basically buy a modified reverse bond from the bank.

Upon receiving a lump sum, you start paying back a combination of interest and principle every month. The value of this bond/mortgage is represented by the interest rate. When you pay back principle early, you don’t have to pay the interest for that amount paid early for the remainder of the loan. Payback $10,000 into your mortgage and you would reduce the cost of the mortgage by that same $10,000 + the interest that you would have had to pay amortized for the remaining term of the mortgage. That remaining interest is your return.

 

 

The concept of “guaranteed return”

One of the many great things about early loan payback is that the return is guaranteed. It’s locked in. This thought of as guaranteed return.

As you can imagine, guaranteed return is an important concept in investing.

Guaranteed return is the “hand-bird” dreamed up by Aesop. It’s the starting point the you use to compare to any other investment.

You need to be certain that before you invest in anything else that the risk-to-return ratio or premium is favorable to you. You don’t want to give up one hand-bird for the chance at only one bush-bird, the risk premium is too unfavorable. Better to just stick with the guaranteed return of the hand-bird.

 

 

Sources of guaranteed return

Other than paying off a loan early, there are a handful investment considered to have guaranteed returns. As you can imagine, for a return to be guaranteed it would need the backing of a large and usually governmental resource. Some of the common investment of this type include your checking and savings account, a CD issued from a bank, savings bonds, TIPS bonds, US treasury bonds, and possibly money market funds.

 

 

The US treasury AAA rated 10-year bond rate is often called, “the most important number in the world”.

The USA 10-year bond is the universal benchmark for guaranteed return. It’s the standard value used to compare the risk premium of every other investment.

Consider this concept. If the return of the USA 10-year bond goes up, there may be a move away from “risk” and towards “quality” or “yield”. If the bond return goes down, the opposite may happen. This has worldwide effects. No wonder President number 45 is so vocal about the Federal reserve and Treasury Department.

 

 

What is the value of your yield on paying back your loan early?

One way to determine the value of paying off your mortgage early is to compare your loan interest rate to the 10-year US bond yield. (You do need to consider taxes into the value, but I’m going to leave that up to you. This discussion is complex enough)

If your loan interest rate is higher than the USA 10-year bond yield, then your risk premium is on the winning side. Payback is starting to make sense.

If your loan interest rate is lower than the USA 10-year bond yield, then paying it back is a losing proposition. Why pay down a 2.7% loan if the you can get a guaranteed 4.2% return on the same assets? In that case, you should invest that extra money. Putting that money into the 10-year bond and using the proceeds to pay off your monthly bill is a nice low risk approach.

 

 

Note: there is some implied risk in a 10-year bond. You could buy the bond and the rate could jump the next year and you locked in or you several other scenarios. These are important when you are a big-time investor or member of a bank board. You may want to just chill about those things…

 

 

Summation:

In this post we reviewed:

  • How you should consider risk and return when determining whether to pay back loans
  • That Paying back a loan is a guaranteed return
  • Other potential sources of guaranteed return
  • If you can find a source of guaranteed return paying higher yields than your loan pay-back that this may make an excellent investment
  • If you still have questions check our Part Seven: I Answer your Questions!

In the next post we'll review

  • How to calculate the Direct comparison between your loan payback and the Stock market

 

 

Remember, the best way to have assets to invest or pay down loan is to earn extra income. Negotiating  a better physician contract is the surest route to more income. Be sure to check out out NegotiationMD.com and our educational resources.

Link to the rest blog series:

 

 

 

So, What do your you think? Does the idea of guaranteed return makes sense? So you feel comfortable comparing bond or loan payback to the bond market? What About investing in equities? How about those hand-birds and bush-birds? Let us know what you think in the comment section.

 

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