Use economics to make life decisions

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Life insurance

Is life insurance a good deal? Dave Ramsey sells it, and certainly thinks it is a good idea. He is opposed to Whole Life Insurance, and I agree with him there. Life insurance pays out in the case of the death of the policy holder, for the amount you claim. If you don’t die in the term, you lose 100% of your money. If you miss a payment, your policy is cancelled, and you lose 100% of your money.

You are literally betting you will die in the term specified by the life insurance. It is truly one of the most cheerful of economic instruments.

With this in mind, here are the numbers for someone with my height and weight in my zip code (your numbers will vary) who doesn’t use drugs:

Mid-20s

Age: 26
Term: 30 years
Limit: $1,000,000
Monthly payment: $51.93

Total payments: $18,694

Probability of death: 1:15

ACTUAL VALUE: $66,666

Stock market value (assuming average S&P 500 yield which is 8% annually, compounded monthly): $72,626.82

Local Bond yield (assuming a 6% return annually, compounded monthly): $50,309

Don’t buy. The stock market will give you a better return than your expected value weighting for the probability of death. If you don’t, then you will fit into the next category for your renewal policy. This life insurance policy is better than local bonds however, but significantly more risky because you have a 100% loss if you don’t die, losing the down payment on a house for no benefit.

Middle aged

Age: 56
Term: 30 years
Limit: $1,000,000
Monthly payment: $556
Total payments: $200,160
Probability of death: 50%
ACTUAL VALUE: $500,000
Stock market value: $777,595
Local bond yield: $538,651

Don’t buy, the stock market is still a better value for your money. Even municipal bonds are a better investment.

These all assume you are perfectly healthy. In both cases the expected value of life insurance is a worse deal than a standard index fund. Life insurance is an extremely risky bet for a number of reasons:

  1. If you don’t die you take a 100% loss on every dollar you spent.
  2. The return once you factor in risk is not as good as it seems without calculating your probability of death.

My recommendation is to start an investment account with Acorns for the same amount you would put into a life insurance policy, because it is significantly less risky (you would only lose all your money in the case of economic Armageddon, whereas with life insurance it is all but guaranteed) and gives a good return compared to other accounts.

Older Senior

If you are lucky enough to live to be 84 in this case, what is your probability? the calculator does not give rates for people over 85. It also limits me to whole life and $40,000 for this scenario.

Age: 84
Term: Whole Life
Limit: $40,000
Monthly payment: $683
Time until stock market matches limit: 4 years 3 months
Time until municipal bonds match limit: 4 years 5 months

Life insurance makes absolutely no sense for seniors to purchase under any circumstances.

References:
http://www.candidmoney.com/calculators/death-probability-calculator
https://www.policygenius,com/life-insurance

Buy a House

One of the biggest decisions in life you can make is to buy a house, it is a long-term asset, and means you never need to pay rent again. But, is it worth it?

If you were to rent out a room in a house, you should expect to pay between $600 and $1000 per month, to live in a shared living situation. This will cost between $7200 and $12,000 per year.

If you were to buy a $200,000 house, you would first take out a mortgage for that amount. You can expect to pay $946 per month for 30 months with a 3.92% interest rate under this system, for a total payment of $340,427.

The obvious advantage of buying a house is that if you move you can sell your house, or rent it out for income, and this means that you can recover the majority of what you spent.

However, this is still not accurate because a home equity line of credit is a better deal still. A Home Equity Line of Credit is going to save you money by putting all of your income into your line of credit when you receive it and then withdraw the money from the home equity line of credit for your monthly expenses. You can further reduce your monthly payments by purchasing on a credit card and then paying off monthly from your line of credit. Do this for two reasons,

  1. Credit cards only charge you on the balance you carry over monthly. If you pay off monthly, you do not pay interest on that card.
  2. You get rewards for using a credit card, if you get the right one. In my experience, airline credit cards offer the best value.
  3. By only withdrawing from your line of credit at the end of the month you reduce your interest owed on your line of credit, saving you years of your life and tens of thousands of dollars.

If you were to do this, on a $200,000 home equity line of credit, with the same 3.92% interest rate, with $4000 of income per month, withdrawing $2000 for your cost of living (this includes everything) you will pay off your mortgage in 11.5 years and spend $41,582 in interest, for a total payment of $241,582.

The best part of all is that after you are done paying your HELOC off, it continues as a line of credit, increasing your credit score.

Also, by using credit cards to reduce interest owed on your HELOC you have saved thousands of dollars, as long as you pay them off monthly. All of this goes to increase your credit score by having multiple accounts with large balances with constantly reducing your percentage of credit used. This works as long as you pay off your cards monthly and stick to the plan.

On the other hand, if you were to take out a $200,000 mortgage as I outlined above you would have spent $340,427.

You can pay more on your HELOC because you can withdraw later if needed, only paying your 3% interest rate as opposed to a 20% credit card interest rate (unless if you have American Express, which is lower). If you had only left the same $946 per month on your Home Equity Line of Credit you would have paid $335,035. This won’t save you much money, but it is still better than a mortgage, saving you $5000. Paying off as much as possible every month is the best deal, and you will not receive fees for doing so.

If you were to rent a room however for that thirty year period (at $750 per month), it would cost you $270,000, and you would have no equity.

Buying a house with a home equity line of credit is obviously the best option.

Buy an annuity

The stock market is too risky you say. You don’t feel good about real estate investing. Some slick financier comes to you and says “buy an annuity from me.”

Should you?

I ran some numbers on Charles Schwab:
If I get myself a $2000 monthly income annuity starting on December 16, 2057, I would have to pay $96,434 in my premium for a guarantee for the rest of my life.

If I have 30 years of retirement than I would receive $720,000 of income in today’s money for paying $96,434. This is about the same amount of money as I would receive if I had just taken $2000 per month out of a retirement account where I had deposited the same $206.06 per month for the next 39 years. HOWEVER, when I die at 95 in 2087 after investing in the stock market I would have almost $3 million saved up ON TOP OF the amount that I had already withdrawn for my living expenses, which I could do with as I please.

Or I could just give those three million dollars to a major multinational bank with an annuity. Guaranteed income… for the bank.

Stock market too risky? Then you could also put your money into municipal bonds, but you will not make enough interest to cover your payments to force you to drain your account by the time you are 95, leaving you with only $100,000 at 95 years old. Going only into municipal bonds is foolish.

You will definitely get the money for life in an annuity, but the return is millions of dollars less than you would make by having a diversified stock portfolio.

If you die early, you would need to pay more upfront for the privilege of getting your money back. Otherwise, the bank takes the cake. How nice of you.

Given the medical advancements which continue in today’s world, I do not think this is a good idea. It does not beat a diversified portfolio in the long run.

My Uncle Wayne died last April at the age of 101. My Onkel Jurgen died at the age of 104 last year. My Auntie Gloria died two weeks ago at the age of 97, the xlast of my great-great aunts. Getting a 20 year guarantee would cost me a lot for no benefit (in all likelihood) and I would probably lose money (taking into account opportunity cost) with an annuity.

A diversified index fund is a better deal.

Divide between stocks and bonds

50/50 split each year, withdrawal from each account

Is it a better idea to move from stocks to bonds in retirement? Is this going to reduce your risk? It will certainly reduce your standard deviation, but this is NOT THE SAME THING AS RISK!

The attached spreadsheet makes this clear. If you put the money you would have spent on that annuity into a diversified index fund, you will hit $2 million in your 100th year and your municipal bond fund will be in the red, assuming you take half of your withdrawals from each account, and deposit half in each account. Sounds like a deal to you?

For comparison, in a diversified stock fund you will hit $4 million in your 100th year.

Sound like a deal to you?

Move money from stock account to bond account after 65

Everything is the same until your 65th birthday, as in all of your money goes into a diversified stock portfolio

Another “safe” strategy is to move money from your stock account to your bond account after your 65th birthday. Let’s say you do this, and you move half of your monthly interest from your stock account to your bond account for “safety”.

Keep in mind that you will retire with half a million when you retire at 65 regardless, and this is from paying only $206 per month each year you work, the same amount the annuity required.

When you turn 100 you will be $807,210.36 short of where you would have been if you had just kept your money in the stock market in your retirement.

Does that sound safe to you?

Keep in mind in the case of economic Armageddon, bond yields will drop to nothing as well.

Learn economics

The stock market is the best investment out there today, as long as you have it through a diversified index fund.

But, let’s say you want to fully understand how to prevent risk? The best way to do this is to learn economics. In order to do this, make sure you study the following before you start:

  1. Calculus 1 and 2
  2. College level Statistics

Economic models which are necessary to understand these concepts are built on these three classes more than anything else.

Then, do the following:

  1. Microeconomic
  2. Macroeconomics

If you are enjoying this so far, continue with these four classes (which I find to be the most useful day in and day out)

  1. Intermediate Microeconomics (how the microeconomic model is derived)
  2. Intermediate Macroeconomics (Solow model)
  3. Economics of Money and Banking
  4. Public Finance, understand how government budgets work and interact with the economy.

This is how you understand the market to ensure you can make good decisions. Ensure you know calculus, statistics, and the first two microeconomics and macroeconomics courses. These provide you with the tools you need to be able to at least tell which economists on TV are telling the truth and which are liars.

There are three podcasts I highly recommend to learn, and that people should follow, those are Planet Money and the Indicator by NPR and Freakonomics. Freakonomics is longer than Planet Money in terms of each episode. The Indicator is nice because it is always about 5 minutes long, and covers a different topic every day. They have guests who are PhD economists, and are together with some introductory courses in micro and macroeconomics an excellent way to get started in the field.

This is one investment which will definitely be good for your financial future. High-quality education is always worthwhile.

After you learn these introductory concepts, you will be prepared to do the calculations I did above, saving yourself millions of dollars.

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