The response to the "should I pay back my loans early or invest" series has been great!
It's one of my most popular blogs. The cool thing is I'm already seeing the conversation change. In forums and Facebook groups. the discussion is now starting to mention the Equity Risk Premium and Guaranteed
Risk Premium. that is just so cool!
As I suspected, the blog series left readers with a lot of questions. I had to purposefully leave some discussions short to try to keep readers.
So in this post, I scour the comments section and add frequent or interesting comments. This post will be updated on a regular basis, so check back. By design it's going to be a little longer to really go into depth
on some topic.
Let's make a deal.
In exchange for all of the great finance information, how about you check out NegotiationMD.com? That way, you learn how to negotiate your physician contracts and become wealthy and I earn enough to keep
this site open and keep doing my best to hjelp the financial condition of my fellow physicians. You should have already downloaded your free spreadsheet from there anyway!
Link to the rest blog series:
- Part One. Intro to the concept of risk premium
- Part Two. The role of risk on Investment
- Part Three. Introduction to Guaranteed Returns
- Part Four. Equity Risk Premium
Part Five. Guaranteed Risk Premium
- Part Six: Decision Making Based On your Loans
- Part Seven: I Answer your Questions!
- Check out the rest of the Blog
List of frequent questions:
Question one From Nitin: How does the guaranteed Return Premium Work? The math doesn't add up!
Feb 17, 2019 on Part five
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.
This is a great question and one that can be a real struggle to understand. Much of the value is indeed virtual.
For this model:
- Your loan 6%
- 10-year treasury 4%
- Anticipated equity yield 10%
Should you buy a 10-year Bond?
This one is simple - answer is No.
Based on Equity Risk Premium should payback your loan or buy equity?
This one is straightforward as well. You guaranteed loan at 6% is certainly attractive compared to the non-guaranteed equity risk premium at 6%. Of course, the market may turn out to beat the expected returns of
lose in comparison, especially when you take sequence risk into account. Since there is a possibility that either one may be better in an unpredicted way, modern portfolio theory suggests you should invest in
both in an efficient frontier. Depending upon your risk profile 60% payback and 40% equities may be the way to go.
Should you payback your loan based on the guaranteed risk premium model?
This get a little tougher, since guaranteed money above and beyond the available guaranteed income is much more valuable. Here is a model: You are offered to play a game.
You flip a coin and if it lands on heads you get one dollar. If it lands on tails, you lose one dollar. It’s a stupid game and a boring bet since the expected long-term outcome is zero.
The cat running the game is behind with his bookies and he knows that a short of heads will bankrupt him and he’ll be in a wheelchair for life.
Not being the type to welch on a bet, he offers you a deal. Instead of playing the game, he’ll pay 10 dollars to not play at all. Do you take it? Heck yes.
How about if he offers 5 dollars? 1 dollar? 50 cents? 1 Penny? The answer is yes to all! You are trading a guaranteed outcome against the chance to win it all or nothing. The same holds true for your loan.
The going guaranteed rate is 4%. Would you like to get a guaranteed rate of your loan at 6% compared to the standard 4%? Please and thank ma’am! Anything above 4% would be a great deal compared to the
risks out there. It’s guaranteed!
There are two ways to approach the extra value of the guaranteed rate.
1. You take your loan (6%) and compare it to the equity risk premium (6%) and ignore the fact that extra guaranteed return is super valuable. There’s nothing wrong with this approach. Just realize that you are
adding more risk than your approach clearly defines. The reason is that your loan return at 6% is more valuable than a non-guaranteed 6% equity risk premium, which is an estimated return range.
2. You consider the extra value of your guaranteed return. The more the guaranteed return, the greater the value. If someone is buying $1 for $10 - you’d mortgage your house and let him buy you out. If he’s buying $1 for $1.02,
maybe you’d empty your wallet and try to keep the tax guys ill-informed. The guaranteed risk premium considers the added guaranteed value by a best estimate formula. It’s not perfect but warns you that you need to think twice about to
buying stocks at an Equity risk premium of 6% when your guaranteed return is 2% better than the best guaranteed return available in the market (6%-4%=2%). It adds that premium to your loan to account for the difference. That part if
the confusing part.
Question Two: Can you do an analysis of current market numbers?
Sure. In the examples from the blog I purposefully use round numbers to allow the reader to focus on the concept rather than the numbers.
I am writing this in March, 2019. The numbers I am using will reflect the market values at the time.
I use the ICOC value for estimating equity market return. The ICOC currently is 7.4% (found here). This is the December 2018 number. I usually use the quarterly values, since so much of the calculation is based on earnings and dividends. The earnings and dividend information should be reported in full by the end of the quarter. There’s also usually a full meeting of the Fed as well. You can use your personal favorite technique to determine estimated equity market return. I suggest you use a technical and proven approach rather than the “over-guess-timation” technique employed by many TV pundits- it seems the market is either going to return 15% or experience the greatest cash since 1929!
The 10-year USA AAA+ bond rate is 2.59%
The average 30-year mortgage rate is: 4.12%
What should you do with extra assets?
- Should you invest in Treasury Bonds?
- Easy Answer. 4.12% is > 2.59% so do not invest in 10-year bonds
- Should you invest in the equity market based on the equity risk premium model?
- The Equity risk premium is 7.4-2.59= 4.81%
- Your guaranteed payoff rate of 4.12% is pretty close to 4.81%. An investment split of 60/40 or 50/50 is a reasonable approach.
- Should you invest in the equity market based on the guaranteed risk premium model
- The Guaranteed risk premium is 5.56% 4.12-2.59=1.53 then 4.12+1.53= 5.65
- The Guaranteed Risk Premium 5.56% > The Equity Risk Premium 4.81%
- The difference is not that large, so a 60/40 or 75/25 investment plan is reasonable
Remember, The Equity Risk premium model considers the guaranteed return from the loan payback to be of equivalent “value” as the equity risk premium.
The Guaranteed risk premium model assigns more “value” to the loan payback since the returns are “guaranteed”.
This is more likely to be a more realistic approach. The estimated equity return is an estimation and is hardly guaranteed. The true stock market return can be negative or much higher than the estimate. There is no way to know for certain. That makes the information that one return is guaranteed far more valuable than the relative value of a best guess.
Question Three: Doesn’t paying off your loan tie up your money for the next 20-30 years? Shouldn’t you keep that money in the market to keep it liquid?
When I first wrote this series of blog posts, I was surprised to see this question come up so often. The reason I was taken aback by the frequency of the question is that is really has nothing to do with the question as to whether to pay back a loan or invest in equities. It’s all about understanding how a loan works.
Let’s start by looking at a simple mortgage as an example.
Let pick a $250,000 mortgage (after the down payment and other costs) at 5% for 30 years. Let’s also assume you have $250,000 in savings and investments elsewhere like in your 401k.
As always, I am keeping the tax implications out the equation. It’s just too complicated to cover all the variations and effect of the SALT deduction in different states. I am also assuming no PMI, HOA, or other costs, just to make this simple.
Your Mortgage amount: $250,000
Your Mortgage interest rate: 5%
Your Mortgage duration: 30 years
Your Monthly payment: $1,342.05
Your Total interest payment: $233,139.46
Your Total Mortgage Costs: $483,139.46
Net worth: $250,000 - $483,139.46 = -$233,139.46
As you can see, that extra interest really costs you. Were you surprised at how much your net worth is reduced by the full amount of the mortgage? You might have believed since the mortgage was $250k and the net worth was $250k that your net worth would be near zero… not 230K in the red.
I used this site for the calculation, but there are plenty of calculators out there.
Now, let’s imagine in the first month of the mortgage, you decide to put in an extra $2,500.
Yes, you can put in money at any time to pay down the mortgage and the first month is the least likely time, but I am trying to keep the calculations easy.
After a single $2500 Payment
Monthly payment: $1342.05
Mortgage duration 29 years, 4 months
Reduction of mortgage length: 6 months
Mortgage Interest: $224,726.46
Total Mortgage cost: $474726.46
Amount saved: $8413-$2500=$5,913
Net worth: -$224726.46
I used this site for the calculation
There are a few takeaways from this example
The money you put towards your house/mortgage is already spent. It’s gone. Goodbye. You have committed your future self to pay the amount back in full on a monthly basis over the length of the mortgage.
- It is easy to forget that the money is already spent because the monthly payments seem so much like rent
- It’s easy to lose track of the costs and effect on your net worth since the length of the loan is so long and the amounts are so high. But the effects are there and need to be considered in the big picture.
- Liquidity is not an issue here. The money is already spent and tied up for 30 years! That is the opposite of liquidity!
- When you pay down the loan early, you reduce the length of the loan, reduce the cost of the loan, and increase your net worth. Paying down the loan early creates liquidity!
- The liquidity created is on the “back end” of the loan and can be difficult to conceptualize in the immediate present.
- When you pay down a loan, especially a mortgage, you monthly payment stays the same. The duration of the loan is reduced by the amount of the early payment pus the amount earned on the amortized earnings over the remaining term of the loan.
- Your $2,500 paydown resulted in a 6-month reduction of the life of the loan.
- If you desire to reduce the monthly payment you can ask the lender to “recast” the loan over the original term. This usually costs a few hundred dollars since the loan needs to be re-originated.
- No surprise here, but the total paydown amount is worth more than the original amount. Your $2,500 loan pay down earns $5,913, for a total loan cost reduction of $8,413.
- When you go to sell your house, you will need to pay off the mortgage in full. Usually, this is done with the combination of normal monthly paydown and the amount the buyer pays. If you do early paydown, the amount you owe the back will be less and can be used towards your next down payment or spent in any way you desire
- The early payback money is not “lost” when the house is sold.