Should I Pay Back My Loans Early or Invest? The Importance of Equity Risk Premium. Part One: Introduction

Should I Pay Back My Loans Early or Invest? The Importance of Equity Risk Premium. Part One: Introduction

Paying back your loans early is one of the most common questions in finance. And one of the most misunderstood.

Inevitably, the arguments go something like this.

  • If I pay back my loans early, I get a guaranteed return of 4.12% or slightly less after a tax deduction. You can’t beat that type of guaranteed return!
  • Then someone posts: You dunderhead! You should take that money and invest it at 7% return! Money is cheap, manage the debt and make more money by putting in the market!

The argument goes back and forth forever. Then everyone sort of shrugs their shoulders and acts like there is no real answer.  Six hours later, someone posts the same question and it’s off the races.

 

 

It’s all wasted effort. The answer has been known for decades.

 

Before we get to the answer, I’m going need to take you through several thought experiments.

Yes, I’m a jerk that way. I know from experience that if I just tell you the solution, you won’t believe me.

That’s why I’m dedicating the effort to bring you on this journey with me. If may be a little obtuse in the beginning but stick with me.

This is going to be a pretty long series of posts, because the concept is far more advanced than what is usually discussed, like ETF’s or 401k’s.

Quite honestly, I could probably market this as it’s own paid teachable course or E-Book, but it’s not my main interest.

Link to the rest blog series:

 

 

It will get a bit dense and math based, but take your time and it will all makes sense in the end. Maybe you should get a snack. Pick me a café au lait and beignet while you’re out.  Remember, medicine is hard, and money is easy. You’ll do just fine.


This is a six part series.  Like I said, it’s a complex concept.

It’s a bit crazy to post something this long to a blog. No one has the attention span any longer. But, if you are really interested in learning an important topic that can truly effect your financial future, try to stick it out. 

It starts off a little slow as I introduce risk to bring everyone up to speed, but by part three things get exciting!

 

 

I don’t advise it, but if you just can’t wait to get to the answer you can:

We’ll still have fun though- we’ll run naked in the streets, you’ll get to kick a doctor out of a bank, you’ll compare hand-birds vs bush-birds, and even Wise King Solomon will get a cameo appearance! How’s that for hype!

 

 

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The Banker’s Dilemma:

You are the president of a bank. You have one job and one job only- to get as must return on the money you invest.

Now, this bank is privately owned and is pretty much unlimited. You can invest in anything, if it’s legal and transparent- meaning you must report it to your board every meeting and you don’t want to end up in jail.

 

 

Into your office walks Dr. James D.

Dr. James D wants to buy a house and sees the mortgage rate is 5%. His credit rating is good, and he is gainfully employed. In general, he is a great mortgage risk.

Do you lend him the money at 5%?

Before you read on, try to commit to an answer. It’ll make this more fun.

 

 

Just before you tell Dr James D your answer, you see the back of an investing book that says stocks have returned 8% in the last 10 years.

What do you tell Dr. James D now? Has this piece of information changed the way you think?

 

 

You tell Dr James D that there’s no way I’m going to lend you money at 5% when stocks are getting 8%!

Before being pushed out the door Dr James D pleads, “Every fiscal quarter nearly 350 billion dollars of new mortgages are created! How can banks let that happen if lending money at such a low return compared to stocks is such a terrible idea?”

“Yeah, that is a dilemma isn’t it?”, you think to yourself. There is currently about 15 trillion dollars of outstanding mortgage debt out there. The bank isn’t here to make friends, we are here to make money… Someone must know something that you can’t quite figure.

How do you answer Dr. James D question?

 

 

The can’t lose scheme:

“Eureka!”, you exclaim as you run down the street naked!

Later at the police station, you explain to your friend who is making bail for you that you have discovered the greatest way to make wealth in the world!

 

 

“What I do, see… I borrow money at 4%. Then I invest it at the 7% return in the market. I sit it there for 20 years and then I pay off the loan and interest with the money I made in the market and I pocket the rest for a cool 3% compounded! I can’t lose!”

Your friend looks at you a little puzzlingly and says, “If it’s such a great idea, why hasn’t someone else done it? You think it would be like a universal thing… you turn 18, you borrow money at 4% and then at 65 you pay off the loan with the assets you accumulated and retire to your yacht and drink champagne while watching the sunset…”

Hmm… Why doesn’t everyone do this? People are always talking about how you shouldn’t pay off your loans and you should invest. Someone must have thought of this before.

How do you answer your friend? Try to commit to answer before moving on.

 

 

You tell your friend that everyone else is an idiot, of course.

Your friend says, “Well, what if you borrowed the money in 1999 when the S%P was 1,248? And then in 20 years you sell in 2009 when the S&P is 865? You’d have lost all the money you borrowed plus the compounded interest at 4%. Seems like that’s a big risk.”

“Risk”, you ponder… That’s a term I keep hearing about.

Maybe there’s something about risk that makes stock return more?

It’s almost like I ‘m gaining the chance to earn more return by taking on more risk. But that uncertainty also means, I could lose all or some.

 

 

As you step out into the bayou evening from central lock up with no shirt and borrowed pants (remembering now that you were running down the street naked when you were arrested) you realize that banks charge more for different kinds of loans

The low risk loans like mortgages are cheap. Car loans are more expensive. And credit card rates are through the roof! The banks seem to charge a premium or increased interest return on riskier loans. That must mean something…

Your head hurts and you ask your friend to stop off at Popeye’s on the way home. What you need is some red beans and rice and a nap. It’s been a confusing day.

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Summation:In this post we discussed

  • The ongoing frustrating problem of whether to payback loans or invest in the stock market with extra money
  • The answer has been known for decades, but the math has been an obstacle for understanding
  • Through two thought experiments we discussed how there is a role for loans and risk in your portfolio planning

In the next post we’ll discover:

  • The types of risk that different investment vehicles posses
  • How those risks are related to expected yield or returns

 

 

Link to the rest blog series:

 

So, what do you think? Is this ongoing debate actually solvable? Are you worried about the math? Have you ever gotten arrested for running through the streets naked? Would you give Dr James D that mortgage? Let is know your thoughts in the comment section.

 

 

 

 

 

2 Comments

Bill Yount

Robert, the post is a great read. Thank you for sharing it on our FB Broup Financial Literacy Project.

 

    negotiation2018

    Bill, do you have a link to your site for interested readers?

     

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