Investment Appraisal - My logic and maths right?

sujman

My friend was made aware of an investment scheme by his IFA. In the context of using the money to pay off his mortgage instead, I decided to analyse the scheme for him.

I wanted to check my maths and logic with your good selves to see if I am generally right. Opinions and feedback welcome.

Outline of scheme:


Option 1

When the investment starts - they look at the ftse100 index and then at the end of the 3 year point if the ftse100 is higher than at the start point that you receive 15% tax free. If same or lower, you get 0%.

Option 2

When the investment starts - they look at the ftse100 index and then at the end of the 3 year point if the ftse100 is higher than at the start point that you receive 12 % tax free or if the ftse100 is same or lower than you will receive 3%.

Of course, in all cases the original principle is retuned 100%. Early withdrawal from the scheme may incur penalties.


My response to my friend:


Looks interesting, I think though the way they packaged it makes it look more interesting than it actually is. The 15% tax free after 3 years works out to about a 4.77% tax free savings rate per year (or about 5.96% before tax if you pay 20% income tax, or 7.95% if you pay 40% income tax).

Using your mortgage rate of 3.5% and an investment of £10,000 as an example, you could look at 2 possible options:

1. Invest in scheme and achieve the maximum return or
2. Use the money to part pay off your mortgage

Option 1 - you will make £1,500 as per the example given in the attachment.
Option 2 - by reducing your mortgage by £10,000, you save approximately £1,087 in interest payments.

So option one makes you £413 better off after 3 years. Discounting for an average inflation rate of 2.5%, this is equal to £383 in todays value.

Is it worth it? Well, depends on whether you think you'll get the 15% (i.e. attitude to risk) but more importantly, the potential increase in mortgage rates over the coming 3 years and therefore the higher savings achieved because you have paid off £10,000 against your mortgage.
If the mortgage interest rates went up to 4.8% early in the 3 year cycle, the net returns would get close to zero. Any higher and the scheme actually loses you money.

Because I pay 3.75% mortgage and I would assume the 12% return is the most likely, for me option 1 and option 2 results is practically the same return, so this scheme wouldn't really work for me.

So, what do you guys think?

Lokolo

His mortgage only needs to raise my 1.3% over 3 years, which is easily doable.

His chances of success are 50/50.

Personally I would put the money into the mortgage assuming no early repayment. As long as he has some emergency funds avail.

dunstonh

Given that I dont like structured products unless the terms are worth it and it has a low risk market counterparty, I am not sure.

Mortgage debt is cheap so investing rather than clearing the mortgage is a valid option. Especially for higher rate taxpayers utilising their ISA allowance. However, it is more an opinion and risk attitude than right or wrong.

If you are going to do it I would rather use conventional investments rather than structured. (especially as the terms of these structured products dont look good).

john_s_2

It's probably worth considering that your friend could get 4% risk-free for three years with the Nationwide ISA (which allows transfer ins).

https://forums.moneysavingexpert.com/discussion/401374

Of course, if the money is not in an ISA already (etc etc) then this makes it fairly academic.

Thrugelmir

:spam::spam::spam::spam::spam::spam:

jamesd

sujman, you can get about 4% a year in dividends from a FTSE All Share Index tracker fund and have a good to decent chance of making a capital gain as well.

Lets say that your friend is willing to accept the chance of losing some money if the FTSE falls by more than 50% but wants 100% capital guarantee for any falls less than that, which is a fairly common term in such products.

Your friend could put £780 into a savings product paying 3.5% and £220 into a FTSE All Share Index tracker. After three years here's how it works if the FTSE drops by 50%:

Cash value: £864.80 plus dividends of £26.40 plus £110 for the FTSE tracker = £1001.20 so the guarantee is met.

Now if the FTSE stays the same: cash £864.80 plus dividends of £26.40 + £220 for the tracker = £1111.20. That's an 11.1% gain if it stays the same.

And if the FTSE gains 15%: cash £864.80 plus dividends of £26.40 + £220 for the tracker = £1144.20. That's a 14.4% gain if it's up by 15%.

The gains increase the more the FTSE is up. Your friend has a readily available savings account that pays 3.5% tax free, the mortgage overpayments.

I think that you and your friend should be looking at using a mixture of investments in a stocks and shares ISA and not messing around with structured products that keep most of the gain for the product provider. You can get bond funds paying in excess of 7% a year so why waste your time and energy with things like this? Mix up some bond funds, a FSTE tracker and a global markets tracker and watch to see what the recovery does to your money.

If you're expecting high inflation, overpaying on a mortgage is a mug's move: better to let inflation reduce the real value of the amount owed, then pay it off in post-inflation Pounds after the inflation matching or beating pay rises that you may get.

I'm doing this myself. Taking out an interest only offset mortgage and leaving the money invested instead of making repayments. I could buy the place for cash by selling the investments, but it just doesn't seem worth it with so many good investment opportunities and such low mortgage interest rates, combined with a fair inflation rate.

Jonbvn

jamesd wrote: »

If you're expecting high inflation, overpaying on a mortgage is a mug's move: better to let inflation reduce the real value of the amount owed, then pay it off in post-inflation Pounds after the inflation matching or beating pay rises that you may get.

Therein lies the crux of making investment decisions. Personally, I think deflation (due to reducing money supply) is more likely - see Generali's posts for further information.

With deflation, paying down debt ASAP is the best approach.

JDinho

Both products are pish, the returns barely offer anything over compounded dividend income.

jamesd

Jonbvn, even so, it'd be hard for deflation to increase it enough, for long enough before normal inflation resumed, to beat the investment returns.

Jonbvn

jamesd wrote: »

Jonbvn, even so, it'd be hard for deflation to increase it enough, for long enough before normal inflation resumed, to beat the investment returns.

It seems some would disagree with you.

jamesd

Johnbvn, most of that is just short term noise over a year or two, not enough to cause 10-25 year mortgage payoff decision. Japan is the big one: long term deflation for a couple of decades. If we go there then clearing a mortage fast may be a good move. Japan is also a lesson for those who think that stock markets must go up after going down. Sometimes the cycle gets broken for longer than people can afford to wait.

So far most governments have learned the lesson from both the Great Depression and Japan and have gone for putting lots of money into the system. The Conservative government here hasn't and has gone for a pro-recession approach - large spending cuts in the sort of economic screwup that happened repeatedly to keep the Great Depression going. But the Bank of England is still keeping money supply very loose, so that might be enough to counter the fiscal contraction, perhaps with a resumption of quantitative easing. And the Conservatives are remarkably not complaining much about it, implying that they actually do have some economic understanding that you need to balance the two.

But bank lending remains at very low levels, so that part of the money supply picture isn't so good.

At the moment I think that inflation here is likely to remain generally above zero except possibly for the odd quarter, and I'll hope that the government doesn't manage to drive it down too far next year. Next year is the time that makes me wonder about deflation and stagflation, when the spending cuts really start to hit, if they actually happen.

The ECB is uninspiring, as ever, looking at inflation risk more than economic risk. Would be nice if they eventually lost a little more of the German hyperinflation cultural memory.

For those who don't know why inflation at moderate levels is good: it happens when there's economic growth, which is why the Bank of England inflation target is 2% not zero: 2% is nice stable and steady economic growth. 15%+ sustained probably isn't economic growth, except in rare cases like emerging market economies in a growth spurt and without exchange rate controls.