Such a Deal!

I submitted the following letter to the editor to both the San Mateo Daily Journal and the Palo Alto Daily Post. But in case they decide not to print it, here it is…

I chuckle when newspapers describe public bonds by totaling the payments made over their term. No doubt reporters think bigger numbers catch more eyeballs.

For those who think this is a reasonable approach, let’s walk through a “deal” which is anything but, based on current interest rates.

Assume Person A has a 3.75%, 30 year, fixed-rate, $1 million mortgage. Total payments will be $1,667,216.13. Person B offers to “help” Person A by taking over the loan. All Person B asks for is a fee of $1,125,000.

Person A, excited to save over $540,000, takes the deal. She’s saving almost a third of what she’d otherwise pay!

Person B has no risk from this deal. The mortgage payments will come from a risk-free 30 year Treasury bond, earning about 3%, bought with Person A’s fee. Person B earns over $40,000 for his “trouble”.

This is a terrible deal for Person A. For one thing, she’s paying Person B more than the outstanding balance of the loan.

By thinking in terms of total payments, Person A ignored what finance professionals call the “time value of money”. Cash in the future simply isn’t worth as much as cash you have on hand today. It’s better to repay the loan with those less valuable dollars, even if you spend more of them.

That’s why professionals don’t think about bonds in terms of total payments. It leads to strange and expensive decisions. They focus on the amount borrowed, instead.

We should follow their lead and do the same.

 

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