(This is a post series on a complicated topic. I will be the first to say debt is an incredibly emotional concept and there is no “right answer” for anyone. Similar to my discussions around asset allocation to bonds/equities, each individual has to reflect on their own behavior when it comes to both debt and stock market volatility. These posts are not blanket advice on debt management to everyone.
Despite the above, I believe there is typically a theoretical optimal approach if an unemotional robot were to apply financial models to an analysis for any given set of variables. My goal here is to help readers understand each variable and their individual importance weighting on a multivariate problem. Once you understand the practical data, you can meld it with your emotional behavior to optimize your own situation.
The last post introduced the concept of the Rent To Own Retirement Portfolio as a thought experiment to evaluate different variables in the debt vs invest conundrum. It is essential to read the initial assumptions laid out to understand the modifications discussed in this post.
As a quick reminder of the first example:
Rent to Own Jane 30 yrs = $100K down, $400K borrowed @ 30 yr 5% interest loan. $2130/mth P+I loan payments for 30 years. No extra savings except loan payments and growth of initial capital
Early Savings Jane 30 yr = $100K down, $2130/mth deposited every month for 30 years. No borrowed money
Delayed Savings Jane 20 yr = $100K dowm, $2130/mth deposited every month for 20 years. No borrowed money
Delayed but Double Savings Jane 20 yr = $100K down, $4260/mth every month for 20 years. No borrowed money
The previous post had a section discussing capital allocation and debt. It made the statement that any new extra capital that does not go to paying student or housing debt, but is instead allocated to an investment is mathematically identical to borrowing directly to invest.
This is a fundamental concept that one needs to wrap their head around. This concept opens the door to understanding how minimally paying down student/housing debt in the early part of career is similar to creating a Rent to Own Retirement Portfolio like Jane in the last post example.
Low Investment Returns
As I mentioned at the end of the last post, there were many rosy assumptions placed into the initial premise that could skew the data to make Rent To Own Jane look great in her decision. The goal now is to evaluate the downsides for Rent to Own Jane and figure out how much pain she could experience if rosy assumptions don’t go her way.
The first legitimate question is what if the investment returns are lower than 7-8%? I have always thought that if I can’t get an investment return that beats my interest cost, it is a no-brainer to pay down the debt!
This assumption seems pretty safe and would be classic conventional wisdom. Most early grads feel comfort on the guaranteed return from debt repayment versus the hypothetical return of an investment portfolio.
The first pessimistic assumption we should make is that investment returns for 30 yrs are sub-par and in fact NEVER beat the 5% interest cost that Rent to Own Jane is paying for the ENTIRE life of the loan. There are many reasons why I think this is a very unlikely expected outcome based on historical data, as long as Jane keeps a solid equity/bond mix of at least 60-80% equity/ 20-40% bond, but the point of this downside analysis is to make bad assumptions.
The 4 categories are Rent to Own Jane 30 yr, Early Savings Jane 30 yr, Delayed but Double Savings Jane 20 yr and Delayed Savings Jane 20 yr.
All 4 categories will be analyzed with 4 and 5% compound investment returns, while Rent to Own Jane will be the only unfortunate one who has to pay 5% interest over 30 years without making higher returns. Rent to Own Jane’s main advantage will be the larger upfront invested capital of $500,000 vs $100,000 for every other category.
Results (based on compound interest calculators and mortgage amortisation calculators. I have double checked the numbers and had them peer-reviewed)
Calculations are completed by the same process as the last post which showed a table with 7-8% compound investment returns. The only difference is substituting 4-5% returns this time. Interest cost remains 5%.
|Rent to Own Jane 30 yr||Early Savings Jane 30 yr||Delayed but Double Savings Jane 20 yr||Delayed Savings Jane 20 yr|
|4% compound return||$1.62 million||$1.78 million||$1.77 million||$0.94 million|
|5% compound return||$2.16 million||$2.17 million||$2 million||$1.13 million|
A few observations here:
- Do not forget that Rent To Own Jane has “wasted” $370,000 of interest to the bank on a 5% interest rate over the life of the loan.
- Despite the interest cost, the Rent to Own Jane portfolio is very comparable in final portfolio amount to The Early Savings 30 yr and Double Savings 20 yr Jane.
- Even when the return rate of 4% DOES NOT BEAT the 5% interest cost, the Rent to Own portfolio comes pretty close to Early Savings 30 yr and Double Savings 20 yr. I would consider the slight difference in portfolio amounts here to be negligible.
- The Rent to Own 30 yr SIGNIFICANTLY OUTPERFORMS the Slightly Delayed Savings 20 yr DESPITE not achieving a higher return than the interest rate! Rent to Own 4% return actually beats Delayed Savings 5% return by a healthy margin!
- Out of interest sake, I analyzed when the Slightly Delayed 20 yr Jane scenario would finally beat the Rent to Own portfolio. The total compounded return had to drop to approximately 1%/ year for the two to finally almost break even despite Rent to Own paying a 5% interest rate for the life of the loan! That’s crazy – an early start to compounding and larger upfront capital is a huge advantage in investing.
How Does The Rent To Own Portfolio Do Alright In A Low Return Environment?
I have to say I was pretty surprised by these results.
My first instinct told me that the reason Rent to Own Jane held up against the 20 year categories was because of the 10 year extra savings. This theory was quickly shot down:
The Rent to Own portfolio had 10 extra years of forced savings of
$2130/mth x 12 months =$25,560 per year x 10 years = $255,600 total extra dollars saved
Yet the Rent to Own portfolio paid out ~$370,000 in interest at the 5% interest rate. This means the results had little to do with extra savings. If anything it leads to a -$115K balance ($255,600 saved – $370K interest) on the saved dollars vs interest cost.
The really interesting finding was that Rent to Own Jane at 5% investment returns pissed away $370K in interest and never beat her interest cost, but came out EQUAL to Early Savings Jane 30 yr despite the interest cost headwind and having the exact same time to compound over 30 years.
How could this be???
The key message here is : The FINANCIAL ASSET is growing on a compound basis, while the DEBT is declining on a SIMPLE INTEREST Basis.
That sounds simple but isn’t intuitive. Let me try to explain.
Everyone is pretty used to the mortgage concept. As you make housing payments, you pay principal + interest (P+I). The principal payments are initial low, but pick up steam near the mid to end portion of the loan. Interest cost tends to be high initially and taper off near the end. One key feature here is that the loan balance is always declining and therefore the interest is being charged on a lower loan balance.
This is fundamentally different than “bad debt” we are used to hearing about such as from credit cards. In this bad debt scenario, making your minimum payment allows the interest to compound and lead to a higher owed balance with a larger interest payment. This form of debt is actually compounding and can lead to a debt growth spiral! This form of debt must be steered clear of in all forms!
The Rent to Own Portfolio has the big advantage of larger upfront capital of $500K. Despite the interest cost, the growth keeps compounding upward where the debt declines on the graph above. This is what makes the magic happen for Rent To Own Jane!
I’m not smart enough to break out the numerical proportional weighted value of the absolute invested capital vs the time horizon of compounding. My guess is that in a moderate to high (5% or above) type investment return environment over a long period, the absolute amount of initial invested capital likely has more value/effect than the time horizon.
Do any math savvy readers have a calculation we can use to estimate the weighted effect?
Higher Interest Costs
Thinking of high interest costs like credit cards gives me nightmares. It should invoke an immediate sense of repulsion to think of high credit card interest. Yet even the average Canadian not in credit card debt needs to worry about higher interest rates, especially when Canadians have all time high levels of debt.
The biggest concern I hear on the debt vs invest scenario is what if interest rates skyrocket, especially in an environment where we know rates will be on an upward trend for some time. When I was graduating residency, I spent the most time evaluating what if interest rates shot up significantly given they were at historic lows of 2-3%. I have to acknowledge my thinking has been skewed by all time low interest costs. I often get push back from those investors that lived through mid teen interest rates in the 1980’s.
If I had to guess, I would assume most people would guess high interest costs would have the biggest impact on the paying down debt vs invest early dilemma. It is hard to see a scenario of paying high interest while getting poor returns and still doing alright.
To evaluate the downside properly, I need to invoke such a scenario. I need to put Rent To Own Jane through the ringer. I will make the unlikely assumption that over a 30 yr period, Rent to Own Jane will pay 7-8% interest costs, but only receive 5% investment returns for the ENTIRE 30 yr period.
The calculations for this one is a bit different from the first 2 scenario tables, so I will write out the calculations as well.
Example A: Rent to Own Jane ($100K down and $400K borrowed)
Jane has the following costs at 7% interest rate over 30 years:
$2630/monthly payments and a total interest of ~$548K over the life of the loan
Jane has the following costs at 8% interest rate over 30 years:
$2900/mth and total interest of $644K
The return on $500K at 5% compounded for 30 years is:
Example B: Early Savings Jane 30 yr, no loan, and 5% investment return
$100K invested with $2630/mth (rent to own payment for 7%) regular contributions for 30 years:
At $2900/mth contribution (rent to own 8% interest cost):
Example C: Delayed Savings Jane 20 yr, no loan and 5% investment return
$100K down with $2630/mth invested :
$100K at $2900/mth invested:
Example D: Delayed but Double Savings Jane 20 yr, no loan and 5% investment return
$100K down with $5260/mth invested:
$100K down with $5800/mth invested:
The table will make for easier viewing of the results
|Rent To Own Jane 30 yr (5% return)||Early Savings Jane 30 yr (5% return)||Delayed but Double Savings Jane 20 yr (5% return)||Delayed Savings Jane 20 yr (5% return)|
|7% interest cost ($2630/month contribution)||$2.16 million||$2.58 million||$2.43 million||$1.33 million|
|8% interest cost ($2900/month)||$2.16 million||$2.8 million||$2.65 million||$1.44 million|
I had to double check these calculations out of surprise!
1. Of course Early Savings 30 yr Jane and Delayed but Double Savings Jane 20 yr should outperform Rent to Own Jane, given the high long term interest cost of ~$550-650K lost to the bank and a crappy return relative to interest rate.
2. The magnitude of the under performance of the Rent To Own Jane Portfolio is significant, but it held up much better than I expected.
3. Rent to Own Jane beating the Delayed Savings 20 yr Jane scenario by a significant margin astounds me though. I had to push the interest cost to 15 % (YES FIFTEEN) before the Delayed Savings 20 yr Jane finally had around $2.2 million vs the $2.16 million of the Rent to Own.
Time invested and large upfront capital makes this much of a difference folks!
You might be saying this is all interesting, but you plan to be early start Jane and will get the same time invested as Rent to Own Jane. You know the greater the capital amount invested in the beginning is a big benefit, but the interest rate being higher than your long term return is too much risk to take on.
How Realistic Is The Scenario Of Long Term Interest Rates Being Higher Than Investment Returns?
My opinion is the time frame component of your pay debt vs investment scenario has a huge bearing on the likelihood of a predictable outcome. I will refer back to this section of a previous post about stock market volatility to evaluate the likelihood of bonds outperforming stocks:
“How long does your time frame need to be in order to ensure the stock market volatility won’t leave you with a smaller real return than bonds? Prof Siegel has shown this via the following stats evaluating the same time period and the likelihood of stocks outperforming bonds:
- Over 1 year: 60%
- Over 2 years: 60%
- Over 10 years: 80%
- Over 20 years:90%
- Over 30 years: almost 100%
With the appropriate time frame, stocks will consistently be the better strategy for anyone with time on their side. Even investors that started investing in stocks in 1929 when the Great Depression crash happened, their 30 yr period from that start date would have still outperformed every other asset class.”
This study was done with over 200 years of data and with “rolling periods”, which means any 30 year combination including the worst starting points like the Great Depression. Beyond the empirical evidence that it is incredibly likely for stocks to outperform bonds over a 20+ year period, there is the theoretical reason why this out performance will occur. I discuss this in the Stock Outperformance portion of this post. It comes down to the risk premium and the inherent advantages a stock/business has in adjusting to unique economic changes.
Why is bonds vs stocks relevant? The lending rate or interest cost you receive from a bank is tied directly to the government lending rates of a country, so it approximates the government bond rate with a slight increased amount for the bank to earn its profit.
As a very general statement, my opinion is:
If you are looking a 10 year or less investment time frame for your debt vs invest analysis, you are likely taking on too much short term interest rate risk unless rates are dramatically low.
If you have a 20+ year time frame, I think the risk/reward of your investment returns outperforming your borrowed interest rate is quite high.
Based on this downside analysis of high interest costs and low returns, I feel these variables are of less importance than the amount of initial invested capital and time horizon in terms of their weighted effect on outcome. This applies primarily when giving an appropriately long time horizon of 20+ years for the investment to grow.
If you take one key message from this post – good debt declines on a simple interest basis, while a financial asset grows on a compounded basis. The longer the time frame, the bigger this discrepancy becomes!
I still have other significant downside risks to cover in regards to magnitude of absolute debt loads, debt servicing ratios and how taxes or behavioral investing may affect the Rent to Own Scenario. Look out for the next post and don’t forget to subscribe to not miss it!