May 31, 2007, 2:30 am

Compound Interest VS Interest Risk

by: The Financial Blogger    Category: Leveraging Strategies
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I read a post on milliondollarjourney.com about Myths about leveraging into Equities. I decided to add more details regarding the interest risk.

Either we are talking about the Smith Manoeuvre or the RIF Meltdown Strategy; there are always individuals to outline the leveraging strategies’ risks. For example, they claim you have a huge interest risk as your loan is linked to a variable rate. The interest rate can fluctuate over time and cause surprises. Nonetheless, the power of compounding interest can eliminate this risk over time.

Let’s take a 100K investment loan at prime for example. With an expected return of 7,2%, your investment will double after 10 years. Therefore, you will still be paying $6,000 of interest but you will make $14,400 in investment income. Compounding interest make your investment grow over time while you will always pay the interest on 100K.

Would you imagine the interest rate goes more than 14% in 10 years? It is possible. However, you need to remember that the interest paid on an investment loan is 100% tax deductible. Therefore, if your marginal tax rate is 40%, you end up paying 8,4% in real cost of borrowing.

On the other hand, the earned income from your investment will be derived from capital gains, dividends and interest. If you select your investment properly, you should not be paying more than 15% to 20% on your investment income. Then, you would earn $11,520 if you are taxed at 20% while you are paying a net interest of $8,400 if the rate goes up at 14%. The interest rate would need to reach 19,2% in order to offset completely your investment income after taxes.

Let me tell you something, if prime rate goes up to 19% in ten years, you will have better concern than your possible investment loss. Economy would be in such a bad shape that nothing you could have done in the past could save you from the present situation.

It is obvious that you will not always make positive return years after years. However, if you have a well balanced portfolio, you could reach an average of 7%-8% without taking too much investment risk. In regards to the interest risk, I think I made it clear for everybody that it becomes a minor effect after ten years of investment.

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Comments

Your analysis is incorrect because you are comparing apples to oranges. First you are comparing nominal dollars over 10 years. Second, your 14% interest is incorrect (4th paragraph. The correct number is 10.5%), because you are not even adding the nominal interest payments you made over ten years ($100,000 + 10 * $3,600 is your total investment. $14,400/$136,000 = 10.5%). You’ll also have to adjust the comparison to reflect that opportunity cost of the interest payments you made in each of the ten years.

That’s a pretty good post, Mikael. In fact you’ve outlined the reasons I am doing leveraged investments myself.

I should clarify that my concern about interest rate risk with respect to debt has to do with cash flow.

I’ll give you an example (which looks suspiciously like my own situation).

My example is a person who pays $1500/month in mortgage payments and is comfortable with that amount – they can live a normal life and even make extra payments on the mortgage.

What if their payments were $1800/month? They can still live fairly normally although the extra payments will stop.

What if their payments go to $2100? At this point, they have to start cutting things out of their normal activities in order to make ends meet.

If payments go above $2400? They have to cut back to essentials and maybe have to get help from parents if payments go any higher.

Ok – that’s our example person.

What if this person/couple wanted to buy a new car/ do a house reno/ borrow to invest? I’m suggesting they shouldn’t just blindly assume they can always make the interest payments just because they can make them if the rates don’t change.

What this person has to do is figure out some scenarios where interest rates go up…and not 21% either, what if the prime rate goes to 8%?, 9%? and see the effect on their payments and their lifestyle in order to better determine if they want to add that risk.

In the case of my sample person – they probably can handle some extra interest rate risk by locking in their mortgage for a period of time and making sure they pay it down. They also need to assess the floating portion and make sure they can handle increased payments if rates go up (even a little bit) and adjust the extra amount they borrow accordingly.

Some people can handle borrowing $250k for investment purposes quite easily, some other people shouldn’t borrow anything. My point is that you need to do proper analysis in order to determine how much you can safely borrow.

Mike

Hi CC,
I don’t know about apple and oranges as I usually don’t go at the grocery store 😉
Seriously, I actually simplified the calculation to make my point without exhaustive spread sheets of numbers. As the investment is in nominal value, I also used the same for the interest paid. $6000 a year will definately not mean the same thing ten years from now. Same thing for the investment.

This is the risk when doing such calculations as they are so many ways of seeing it. I could have also calculated the compound interest on the tax return supposing that many strategies are adding this money to the investment.

Nonetheless, I think the calculation still shows that interest risk is a minor factor in the long run.

I would be curious to see your modified calculation. It would be great to have a full second thought on this topic.

Cheers,

FB.

Hi Mike,
I can appreciate your point with your explanation. However, I classify this situation under the cash flow risk instead of interest risk. Leveraging strategies are definitely not for everybody as you need to make sure you have enough money to cover the monthly payment with any rate fluctuation.

Cheers,
FB.

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