I’ve had to wipe egg off my face numerous times back in the day, due solely to unfinished analyses. Nobody’s so good they can foresee the end game of a given analysis. I know I’m sure not. Over the decades I’ve learned the hard way that what appears to be the analytical conclusion is too many times a mirage. Here are a couple examples — one simple, one a bit more involved.
The common denominator between the two is that on the surface, the answer appears quite obvious to most.
2 Examples That Prove the Importance of Analyzing Your Investments
Example #1: Higher/Lower Interest Rates
What’s the difference between 4% and 5% interest? Well, there’s a buncha difference, right? Much of the time, that’s true. However, let’s test it with a quick analytical comparison.
You’re buying a duplex that will have a new loan of $200,000 with a fixed rate, amortized for 30 years. You can pay 4% with no points or 5% with a point, which is $2,000. You know you’re gonna add $1,000 a month either way to the payment in order to speed up the loan payoff.
Clearly, the 4% rate is vastly superior, right? Well, maybe.
A quick check on the HP 12c shows us that adding $1,000/mo to a $200,000 4% loan payment will result in that loan being paid in full in 126 months, 12.5 years. Doing the same with a 5% loan payment will pay it off in 124 months. Whoa! Wait just a dad-gum minute! How is that even possible in a sane world?! I’ve been the happy recipient of countless free drinks and a few free meals with that bet. 🙂 So, the loan is paid off sooner, you pay a couple less payments, plus you saved the $2,000 upfront point.
There’s a hidden Bazinga! in there. Can you tell me what it is? Think about your assumptions.
Example #2: Why on God’s green earth would anyone take 12-15% yield returns to pay off 5% debt?!
I can’t count the times I’ve been asked this question:
“Jeff, you’ve sold me on the value of having discounted notes as part of my Purposeful Plan, but why would you tell me to take note payments to pay off cheap real estate debt? That makes no sense to me.”
Once again we have data showing something appearing to be Captain Obvious(ly) incontrovertible. Let’s do the analysis, though, before we bet the ranch on our premature conclusion.
Teresa Investor already owns notes generating $1,000 after tax, monthly. Her two best options for that income to enhance her ultimate after tax retirement income are: a) accumulate the payments ’til she has enough to buy another note or b) use those payments to retire the debt on one of her properties. It’ll take her five years to pay off the $200,000 loan. She’ll be using three sources to do this: note payments, rental property cash flow, and her own money.
NOTE: Please notice that two of those three sources are coming from other people’s money.
Her choices in this scenario boil down to: a) buying more notes with accumulated after tax note payments, while taking years longer to eliminate her duplex debt or b) eschewing the first option by committing the note payments to the more rapid duplex loan payoff.
Let’s take a look.
In five years while applying Option A, Teresa would be able to acquire $60,000 in discounted notes. Being conservative, we’ll assume she’s making 12% cash on cash yield, which would be $600/mo or $7,200/yr before taxes. We’ll apply a 35% state/fed overall tax bite, which leaves her with around $4,680/yr. At today’s prices she’d have had to wait 2-3 years to have enough to make each purchase.
On the other hand, if she chose Option B, her duplex would be free ‘n clear in just five years with a value of $300,000, what she paid for it. She would then have multiple alternatives as to what her next move might be.
- Would a sale work? Sure, if the capital gains taxes were reasonable. But that begs the question: What then?
- How ’bout exchanging all that equity into much more? Yeah… but remember, tax deferred exchanges should be avoided if at all possible. Even though I’ve done well over 200 of ’em, they should be the last resort.
- Since she wants to have her cake and eat it too — and who among us doesn’t — she opts to refinance for some cash out. Her lender tells her she can get up to 70% of her equity out in cash. This approach allows her to get that cash without any tax liability, deferred or otherwise. Caveat: Don’t do this, then try to execute a tax deferred exchange shortly thereafter, as the IRS will much more likely than not tax that entire cash out loan amount as “Boot.” Oh, and they’re the sole arbiter on what your intentions were, and how “shortly thereafter” is defined. 🙂
Teresa then pulls out $210,000, which she immediately uses to acquire more notes. Using the same 12% cash on cash yield, that gets her an annual income of $25,200, or $2,100 a month. Now, tell me again how it’s horrible to use 12-15% yields to pay off 5% borrowed money? 🙂
Her duplex is still cash flowing at around $5,000 annually, so it’s easily paying for itself. Out of the extra $2,700 she added to her monthly payment for 60 months, a little over half came from other people via cash flow and note payments. Her overall Purposeful Plan had already designated her personal money, about $1,300/mo, to go to accelerating her duplex loan payoff. If she’d kept to that original plan instead of being free ‘n clear in just 60 payments it woulda taken her an additional three years and eight months to get it done. What would have been the opportunity cost for those extra 44 months?
Simple: $210,000 X 12% discounted note yield/yr X 3.67 years = $92,400 missed income.
Let’s say when Teresa did this she was 55 years old after the first payoff/refi. Let’s further assume that the interest she paid for the refi wasn’t 5%, but 7%. That would lower her post refi cash flow from around $5,000 yearly to a bit under $1,800. How quickly might she pay this new loan off, if that’s what her Plan called for?
She can still comfortably afford to contribute the same $1,300 monthly from her own budget. She’s not gonna count on $150/mo duplex cash flow this time. Her after tax note income as grown nicely to around $2,350/mo. This gives her $3,650 monthly to add to her duplex loan payment. How does that work out for her?
In a month less than six years — 71 months — she’s already free ‘n clear again. She’s now 61 years old, about four years from retirement. Should she call it a day?
IF she opts to rinse ‘n repeat the ‘refi and buy more notes’ script, here’s how it might play out.
She gets the same $210,000 tax free cash. Gets the same 12% yielding $25,200/yr pre-tax. Her after tax is the same $1,365/mo as before. However, she now has her $1,300/mo; no contribution from the duplex; and an after tax total of around $3,730/mo from her now slightly impressive discounted note portfolio. The grand total she can now add to another potential $210,000 refi payment is $5,030/mo. But does that fit into her timeline for retirement?
Well, whadya know? 37 months later and her duplex is free ‘n clear once again — and almost a year before she retires. In fact, if she wanted to, she could retire right then, almost a year early.
During this analysis we’ve happily discovered a some truths.
- Do the dang analysis to the bitter end, no matter how sure we are about what we “know” is the foregone conclusion.
- Teresa began by contributing $1,300/mo to her plan and never increased that amount during the 14 years she followed her Plan.
- The truth of #2 meant that her contribution was a constantly decreasing percentage of the amount used to pay off these refis. Even at first she was contributing less than half, with other folks doing over half the heavy lifting. By the last refi, which she eliminated in just 37 months, her contribution was merely half a tic less than 26%, meaning roughly 74% of the money used to clear that last loan off came from other people.
Teresa’s plan isn’t formulaic, as one Plan doesn’t fit all. Never has, never will. Not to mention the BawldGuy Axiom saying, “Most investment formulas work right up ’til the day they don’t.” However, the principles upon which the various strategies were founded, never change. She made use of Strategic Synergism.
Her immediate retirement income that first year is approximately $87,600 a year, pre-tax. That doesn’t count anything she likely did inside her Roth IRA — or anything else. I strongly suspect, based on nearly 40 years of discounted note experience, that it would easily eclipse six figures. The very simple reason being that this post never assumed any single note she every bought would ever pay off early. The average note these days pays off in a window of 6-9 years. But since they’re virtually the perfect working definition of random when it comes to paying off, we can’t ever apply that average to a particular note. It’d be more than foolish.
Do the analysis every time, and do it to the last decimal point. The idea is to be accurate, not show how smart we are. 🙂 As I said at the beginning, refusing to do the entire analysis (or sometimes multiple comparative analyses) is a lock to wiping a whole lotta egg off your face.
Investors: What do you think? Have you ever run the numbers on an investment, only to find that the results shocked you?
Leave your opinions, comments and stories in the comments section below!