Should I Pay Back my Loans Early or Invest? The Guaranteed Risk Premium. Part Five.

Should I Pay Back my Loans Early or Invest? The Guaranteed Risk Premium. Part Five.

Using the Guaranteed Equity Risk Premium to determine your individual situation and course of action.

This is part five 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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This is a tough concept, and many get hung up here. Don’t feel silly if you need to read it a few times and go back to the precious posts to review things.

Let’s go back to the Aesop hand-bird and bush-bird model.

 

 

Remember, one bird in your hand is worth two in the bush. Because it’s far more likely that your bet on bush-birds will result in one or both birds flying away, you assume risk in that investment. That risk results in a premium of 1 hand-bird to 2 bush-birds. So, if you had a standard hand-bird you would need a premium of at least two bush-birds to make the trade worthwhile.

The hand-bird is guaranteed return and equivalent to a USA 10-year bond. The bush-bird has implied risk and therefore greater reward and demands a premium. The bush-bird is akin to stock market investing.

 

 

But what if your hand-bird was worth more than a standard hand-bird?

I know this may sound crazy, but this is exactly what could happen to the guaranteed return on your loan if you intend to pay it back early.

Here’s how this can happen, in a way simplified manner:

  • Let’s say you made a deal. You would accept 10 hand-birds now. In return, you’ll pay 16 hand-birds plus the original 10 hand-birds at the end of 24 years.
  • Essentially you have taken a loan for 10 hand-birds now to be paid back with an additional 16 hand-birds over a length of time. So, in 24 years, you’ll have a lump sum payment of 10+16= 36 hand-birds.
  • You realize that for every 4-year period that you hold the loan, you owe an additional 1.5 hand-birds.
  • Your lender agrees, that for every hand-bird paid back early, you can remove extra owed hand-bird. But he states that for every 4-year period that 1.5 hand-bird will be owed, even if you paid back the rest in full. (I’m ignoring compounding interest on purpose here)
  • It seems like a fair deal. And, if you run into a trouble trying to figure out how to pay a half-hand-bird there’s always Wise CFO Solomon at the Jerusalem Temple Employee Credit Union for advice. (see, I told he’d make an appearance!)

 

 

Now, after taking the loan, you have a great a hunting season and you end up with two extra hand birds. What’s the value of your hand-birds? Is it one bird in hand to two in the bush? Or is it more?

Since for every hand-bird that you put toward the loan, you avoid paying 1.5 hand birds in the future. That makes your hand-bird worth 1.5 standard hand-birds!

Should you invest your two-extra hand-birds in the bush-bird market for the standard rate of one hand-bird to two bush-birds? That is, your two hand-birds for four bush-birds?

 

 

The surprising answer is no!

Why. Because the birding risk is still there. Remember, each extra hand-bird is now worth 1.5 hand-birds if you pay your loan down early. Your two 1.5 valued hand-birds combined are now worth three standard hand-birds.

You’ll need to get six bush-birds for fair return on your investment.

Your two-extra hand-birds are now worth six the bush! You should pay down the loan!

 

 

Here’s the concept that many people stumble upon.

Your guaranteed return is not the same as the standard USA 10-year treasury return. In this scenario your yield is better. And that increased yield is worth a premium.

Your guaranteed return is the interest rate of your loan plus the increased value compared to the standard rate. Let’s say the following were true at the time you held extra cash in hand:

  •  Your mortgage rate is 5%
  •  The USA 10-yield is 3%
  •  The estimated equity return is 9%
  •  The Equity Risk Premium is the ICOC (9%) minus the 10-year yield equals (3%) = 6%

Everyone is screaming at you to invest in the stock market. Even the simplest Dunderhead knows that 9% is more than 5%!

Should you invest in the stock market which is currently paying a higher return than your loan?

 

No.

The guaranteed return on your loan is worth more than standard guarantee, even though the Equity Risk Premium is slightly higher than your interest rate. Just like your hand-birds are worth more than the standard hand-bird.

If you subtract from your loan at 5% the 10-year yield at 3% you would get a 2% premium in your loan vs. the standard loan. That’s how much more your loan is worth than the standard guaranteed return.

 

 

That is the guaranteed risk premium you obtain or “put in your pocket” by paying down the loan early compared to the standard guaranteed premium.

Next add that extra value to your loan 5% and 2% = 7%. That’s your guaranteed risk premium.

Here's the math again taking the new information in account.

  •  Your mortgage rate is 5%
  •  The USA 10-year is 3%
  •  The estimated equity return is 9%
  •  The Equity Risk Premium is the ICOC (9%) minus the 10-year yield equals (3%) = 6%
  • The difference between you rloan (5%) and the US 10-year is 2%.
  • The Guaranteed Return Premium is your loan (5%) plus the difference (2%)= 7%
    • That's the guaranteed risk premium. How much more your loan is worth in payback than the guaranteed rate
    • The Equity RIsk Premium at 6% is less than your Guaranteed Return Premium of 7%.

Paying down your loan early now with your cash in hand gets you the equivalent of a 7% risk return. In other words, you would need to get a yield of at least 7% on an investment, to match the guaranteed return on paying back your loan early when you take into consideration to current US 10-year note.

You’ll want to earn more than 7% in the stock market to be worth the risk.

The fact that your guaranteed return premium is better than the standard guaranteed return means paying off your loans is a pretty good value. You should only trade that guaranteed return with premium for an outstanding yield. In the current example, the risk equity premium is 6%. You should probably pay off your loan instead.

 

 

I realize this can be a tough concept to wrap your head around. Don’t feel bad if you don’t fully get it the first time. Some days, even though I studied the concept for nearly a decade, I just get thoroughly confused as well.

Think about it this way- You are getting a guaranteed 5% back if you pay your loan early. That’s a 2% better return than the standard guaranteed 3% US treasury return. Now guaranteed is way better than non-guaranteed!

How much better? In bird terms 1 guaranteed bird is worth 2 non-guaranteed birds. In comparative terms of your loan, that 5% guaranteed return is 2% better than the standard guaranteed return, so any non-guaranteed risk you take need to match that 2% guaranteed plus add some extra return to make it worthwhile.

I would want at least an 8% and hopefully 10% non-guaranteed return before I risk a 5% guaranteed return in 3% standard environment.

Hopefully, you can see why all the peanuts in the gallery shouting at you that you’re a dunderhead to pay down your loan at 5% when the stock market is paying 7% are of dubious trust or understating of all the underlying market forces.

 

 

You can also know answer the two thought experiments in the first post. A loan to Dr, James D at 5% is a pretty good risk and return. Give that Doc a Mortgage. Borrowing money at 4% and investing it has a high level of risk with an implied return of only 2-3%. Sure, it can pay off. But woe is you if it doesn’t. That loan will continue to compound whether the market agrees with your bet or not.

Despite the joy of running around the town naked, the risk of borrowing money that you must pay back does not give you a winning edge. Borrowing money chasing equity returns is ultimately a losing proposition. It’s like the guy who borrows money from a loan shark to bet the ponies. One or two bad days at the track will put you in a wheelchair for life.

We are now rounding third base and heading into home! In the next post we review how to use all of this to make decisions regarding your loan.

 

 

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:

 

 

 

In Summation:

  • You can use the Equity Risk premium to determine is you should invest is guaranteed return investments or the stock market
    • You can extrapolate this somewhat for loan payback
  • If your loan is at a higher interest rate than the 10-yr treasury yield then your loan payback is worth more than the standard guaranteed rate.
  • You can determine your Guaranteed Return Premium by the method described above
  • You should use your Guaranteed Return Premium as a better comparator for decision making
  • If you still have question check out Part Seven: I Answer your Questions!

In the next post we'll discuss decision making based on the Equity Risk Premium

 

 

 

So what do you think? Does this complex concept make sense? Can you see the value of the guaranteed risk premium? Are you favor hand-birds or bush-birds? Has this idea changed the way you look at loan payback or stock market investing? Let us know your thoughts in the comments section.

 

 

6 Comments

Nitin

Isn’t the Guaranteed Return Premium 5%-3% = 2%? You get a 5% return on paying off the mortgage, but you can’t use that money to earn 3% in a 10-year treasury.

I don’t see where a 7% return is coming from.

 

    negotiation2018

    The equity risk premium is the stick market vs the standard guarantee (10-year bond)
    But your loan is not the 10 ten year bond. It may be worth more.
    There are 2 ways two look at
    – you can compare your rate direct to the equity return, But, that doesn’t take into effect the guaranteed nature of the return. They are not comparable.the stock market has risks. The payback has none.
    – you could compare how much more valuable your guaranteed rate is by adding the difference premium.
    up to you how you wish to look at it. At least take the premium into mind

     

      Nitin

      My main concern is you have to also account for the fact that when you pay the bank back early, you have entirely given away your capital – and that has to be accounted for too. You have less flexibility for emergencies, and less opportunity to buy into a cheap asset class if the opportunity arises.

      My version of this would be different:
      “Next add that extra value to your loan 5% and 2% = 7%. That’s your guaranteed risk premium”
      It would loan 5% plus 2% (risk premium) minus 3-9% (loss of investment yield from a treasury, stock, or optionality to invest in an asset of some kind) = 4 to negative 2%.

      Also, the early mortgage payoff saves you money at the end of the mortgage (payoff by year 23 instead of 30, for example). By then, your $3500 monthly mortgage payment is worth just a month’s groceries. Meanwhile, your FedEx or Google stock might have compounded 15X and is paying you an annual dividend equal to half your original investment – every year, again and again.

       

        negotiation2018

        Payback of a loan is immediate not delayed
        look at your net worth= assets – debt
        When you pay back your loan the amount is amortized and applied immediately. You net worth goes up that day. That’s the beauty of guaranteed return
        Net worth = Assets – (debt-reduced amortization of loan payback)

         

        negotiation2018

        I do like your view of the equations. You are looking at from the equity side while i look at it from the guaranteed return. As you know, I’m a big fan of looking at equations both ways. Your post has inspired me to edit the section above in a more graphic manner to look at it from the equity side. Hopefully in the next week or so

         

        negotiation2018

        Don’t confuse expected return with guaranteed return.
        Think about the banker’s dilemma from the first post. If your supposition was correct, why would any bank lend money at 5% for 30 years as part of a mortgage.
        Your fedex or google stock just might have been sears, radio shack, enron, or payless.

         

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