Nerd's Eye View Archives On General Financial Planning

Why It’s Best To Measure Risk Tolerance With #FinTech Questionnaires Instead Of (Just) Risk Conversations

November 27, 2019 07:08 am 5 Comments CATEGORY: General Planning

There are numerous factors that every advisor must consider when objectively assessing a client’s risk tolerance. And if the concept of risk wasn’t already complex enough (as it considers a multitude of facets, including tolerance, capacity, composure, perception, and literacy), the variety of available tools to measure risk tolerance – from written questionnaires to various FinTech software tools and simply having the advisor-client “risk conversation” – often results in inconsistent (or even contradictory) results (especially given that clients vary in their own risk literacy to navigate such assessments in the first place).

In addition, recent research reveals that the modality of the risk tolerance assessment process can itself influence the results. For instance, one study found that when advisors verbally discuss risk tolerance with clients of the opposite sex, the client’s self-reported risk tolerance tends to be higher than if the client would have responded to an advisor of the same sex. This implicit gender-bias behavior is thought to be driven by subconscious psychobiological tendencies of the client, possibly influenced by a desire to appeal to a person of the opposite sex (even if not otherwise attracted to or interested in them).

In turn, alternatives to the conversational approach to risk tolerance – such as using pen-and-paper written questionnaires, or FinTech-based software tools for assessment – also appear to have an influence on the results. For instance, while scores for men and women were equal in a pen-and-paper assessment, men scored significantly higher than women in a technology-based video assessment that included the exact same questionnaire as the pen-and-paper test. And although it might be tempting to conclude that the pen-and-paper assessment is better for eliminating the gender gap between men and women, studies have shown that an inherent difference in risk does indeed exist between the sexes, where men generally report higher risk scores than do women. Given that this gender difference was preserved in the technology-based assessment suggests that perhaps gender-neutral technology-based assessments may have the edge over pen-and-paper assessments in most accurately assessing clients’ risk tolerance levels.

On the other hand, it’s also important to recognize that not all technology tools are similar for assessing risk tolerance. In practice, risk tolerance software can be best leveraged by understanding the methods used to measure risk tolerance and also by knowing how risk literate clients are, as certain assessment modalities may resonate more for clients depending on their risk literacy levels. For instance, clients who are highly risk-literate may relate better to econometric measuring technology, such as the software platform provided by Riskalyze. Other less risk-literate clients may relate better to FinaMetrica, another software platform that relies more on psychometric criteria than economically complex quantitative risk trade-offs.

Despite the advisor gender bias observed in risk tolerance studies between men and women and the appeal of gender-neutral technology risk measurement tools that are readily available, conversations with clients should not be eschewed altogether. Instead, they may be effectively used after a (software-based) risk tolerance assessment has been administered, and perhaps by a team of male and female advisors, not only to review the assessment with the client and help them understand the results, but also to supplement the process with a human element involved in helping clients improve their overall risk literacy. Because technology tools are still no match for a person-to-person connection for an advisor to gather the subtle nuances about their clients that software programs are simply unable to detect.

Ultimately, the key point is that there are many factors affecting how clients perceive their relationship with risk, and at least some of these are subconscious influences on human behavior. And as technology-based assessment tools may minimize a client’s bias that can arise in response to their advisor’s gender (while leaving the inherent gender gap that exists between men and women intact), connecting through conversations in person (after the technology-based assessment is administered!) is still the best way to grow relationships and develop trust with clients.

Protecting And Guiding Clients With Diminishing Mental Capacity

September 30, 2019 07:33 am 2 Comments CATEGORY: General Planning

With an ever-increasing number of seniors afflicted with dementia, most financial advisors should expect to have to deal with (if they don’t already) clients experiencing diminishing mental capacity. Which are often challenging situations to deal with, not only for the complexities of the clients themselves, but also because client privacy rules can limit an advisor’s ability to involve other family members or to intervene if outright elder financial abuse of the diminished-capacity client is discovered. And while there has been regulatory progress towards protecting seniors from abuse (and allowing advisors more ways to involve family members and outside providers), it can still be very challenging for advisors to figure out how best to handle these relationships.

Importantly, though, financial advisors are in the unique situation of potentially being among the first to recognize that symptoms of diminishing capacity ailments are beginning to develop in the client, as indications of impaired financial capacity may be noticeable long before a formal diagnosis of dementia is made. Furthermore, given that seniors with diminishing mental capacity are potentially the most vulnerable to financial exploitation, it’s especially important for financial advisors to be aware of these risks, and to know what to do if they suspect (or know) that their client is being victimized.

In this guest post, Steve Starnes, a Principal with Grand Wealth Management in Grand Rapids, Michigan, discusses what client diminished capacity actually entails, how regulations protecting seniors (as well as guidance for advisors who serve them) have progressed, the importance of documenting goals, key relationships, and investment plans, and how advisors can help clients manage through the various stages of cognitive decline.

As a starting point, the most basic challenge is simply understanding the relatively vague nature of what ‘diminished financial capacity’ actually means… both for clients (and their loved ones) as well as the advisors who serve them. As while it’s easy enough to peg a definition on the term, the real challenge is in recognizing when the client has actually crossed the threshold of their financial capacity diminishing to the point that it actually becomes a real ‘problem’ where action must be taken.

The regulatory landscape paved by Federal legislation, FINRA regulations, and the North American Securities Administrators Association (NASAA) offers another challenge to advisors, who, in the past, were often restricted in involving authorities, but now in some cases may instead be required to report suspicions of financial exploitation. Fortunately, at the Federal level, the Senior Safe Act provides some level of immunity to advisors who report incidents of potential financial exploitation against seniors. NASAA is on the same track at the state level, encouraging states to adopt its Model Act which also grants advisors immunity for reporting suspected financial exploitation. Further, NASAA’s Model Act also allows for advisors and broker-dealers to delay disbursements from a client’s account if they suspect their client is a victim of financial exploitation. And when it comes to brokerage firms themselves, FINRA has established two rules intended to help broker-dealers protect customers from financial exploitation: Rule 4512 requires brokerage firms to request Trusted Contact Person information for customer accounts, and Rule 2165 allows brokerage firms themselves to put a hold on disbursements if financial exploitation is suspected.

Working with clients with diminished mental capacity creates additional concerns over the business risks faced by advisors and their practices. For example, if a client makes an uncharacteristic request, it’s often hard to distinguish whether the request is the result of a temporary external situation, or if it’s a warning sign of diminishing mental capacity… raising questions of how the advisor should respond and handle the client’s request (or not). The risks inherent in such situations, however, can be mitigated by implementing and following structured processes and procedures that a firm establishes in advance specifically for situations of potential diminishing capacity of clients. Among the most important are documenting (and regularly updating) client goals, values, and investment plans, as well as maintaining a list of their important personal relationships (including the client’s financial power of attorney, the advisor’s trusted points of contact, and custodial trusted contact persons) and getting signed permission in advance for the firm to be able to reach out to the client’s trusted points of contact if a concern of diminishing capacity arises.

Often the biggest advisor challenge, though, is simply the dynamic of trying to communicate with clients who can’t remember basic, yet important, details about their own lives and financial situations. By keeping conversations straightforward and clear, and maintaining patience and compassion during these conversations, client interactions can often remain productive and helpful. If the client’s financial POA is included in the discussion as well, they can help the client understand any confusing points of the discussion, and they may be better positioned to understand the issues around the client’s financial priorities.

Ultimately, the key point is that while there are many unique challenges in working with clients suffering from dementia, advisors have an abundance of resources available to help them navigate through these challenges. And arguably, advisors have an even greater responsibility and duty to clients who may be especially vulnerable to financial exploitation to help protect them to the fullest extent possible. The starting point, though, is to recognize that while financial advisors are typically well-equipped to help clients plan for their retirement, investments, and tax strategies, it’s equally important to create the necessary processes and procedures to plan for what unfortunately is a virtually inevitable reality of at least some clients who will eventually face the onset of diminishing mental capacity and who will need to rely on their financial advisor more than ever.

The New Blended Retirement System For Military Servicemembers

September 11, 2019 09:09 am 5 Comments CATEGORY: General Planning

Since before World War I, the United States has maintained a retirement program in one form or another to incentivize military servicemembers to build long-term careers in the armed services. The last iteration of the military defined benefit retirement system, called the High-36 Retirement Plan (or “High-3”), was established after World War II and required servicemembers to serve at least 20 years before becoming eligible for retirement benefits. The High-3 system calculates retirement pay based on a percentage of the average salary from the highest 36 months (or 3 years, thus the name “High-3”), for those who have met the 20-year service requirement.

In this guest post, Kathleen Boyd points out that this requirement has been problematic, as according to the Department of Defense, an estimated 80 percent of military personnel exit their service before 20 years. Consequently, most servicemembers have departed the military without any retirement savings. To compensate for the all-or-nothing cliff vesting, the military began offering a Thrift Savings Plan (TSP) so that servicemembers could supplement their retirement benefits with their own tax-preferenced savings. However, the TSP under the original High-3 system offers no military contributions or matching elements on behalf of servicemembers; it’s ‘just’ a self-directed retirement savings plan. And consequently, it provided little to no incentive for a servicemember to initiate contributions if they weren’t already self-motivated to do so.

In 2016, Congress enacted substantial changes to the High-3 military retirement system for the first time since it was set up in 1981. The National Defense Authorization Act (NDAA), effective January 1, 2018, was created with the goal of cutting expenses while increasing flexibility for servicemembers to participate and get at least some retirement benefits from the government. From that legislation, the new Blended Retirement System (BRS) was born.

The BRS consists of a blend of a new High-3 system, similar to the old but updated with a decreased defined benefit amount (due to an adjustment of the years-of-service multiplier), plus new provisions for servicemember TSP contributions (to supplement the reduced High-3 defined benefit amount), including a 1% service automatic contribution (‘free money’ that does not depend on the member’s contribution level) and an employer match of up to 4%. Additional benefits of the new BRS system include substantially increased contribution limits for servicemembers working in combat zones, and a potentially significant retention bonus.

Notably, while the 20-year service requirement still remains in place to receive the High-3 pension annuity benefit under the BRS, a servicemember can take the TSP funds (including their own contributions, government contributions, and matches) upon exiting the military (assuming they meet the vesting requirements – matching contributions vest immediately, and the 1% service automatic contributions vest after two years of service).

To facilitate the transition from the old High-3 to the new Blended Retirement System, the Department of Defense established a deadline of December 31^st, 2018 for active servicemembers to make a decision on whether to opt into the new system or stay with the old. Yet even though the deadline for the choice has passed, it’s still important for advisors working with military clients to understand the benefits and risks of this irreversible decision for future planning purposes.

For example, if a servicemember opted into the new plan, they are now set to receive a lower defined benefit amount, but also have access to government contributions and a matching benefit to their TSP. Alternatively, if a servicemember chose to stick with the old High-3 plan, they stay on track to receive the higher defined benefit amount but lose out on government contributions and matches to their TSP.

The key point is simply that there are additional intricacies of the new system that advisors who serve servicemembers of the military need to understand, and that the servicemember’s join date and years of service will dictate not only which plan will apply to them, but also which benefits they will be eligible for. And while the 2018 deadline to choose retirement systems has passed, the decision must still be made by any Reserve members who are redeployed who have yet to make a choice.

How The Financial Planning Process Differs For Young Clients: Not Simpler, But Different Complexities

April 17, 2019 07:11 am 10 Comments CATEGORY: General Planning

The rise of the asset-under-management (AUM) model has driven a concomitant shift in financial advisors to focus increasingly on Baby Boomer retirees – for the same reason that Willie Sutton robbed banks: “That’s where the money is.” To the point that some in the industry have raised the question of whether the pendulum is swinging too far to retirees, and that it’s time to start doing more financial planning for next-generation clients as well.

Except the challenge for most advisory firms is that it’s not profitable to do financial planning for younger clients, who simply don’t have sufficiently-sized investment accounts to generate enough AUM fees for the advisory firm to deliver the advice. For which advisory firms can adopt various “fee-for-service” models, from charging minimum fees based on a percentage of income, to flat monthly retainer fees. Except then the pressure is on the advisory firm to justify the value of the financial planning advice being given to clients for that fee, especially when they tend to have "simpler" financial needs in the first place.

Yet the reality is that younger clients with fewer assets and lower net worth still experience the kinds of tumultuous life transitions that necessitate engaging a financial advisor in the first place. In fact, ironically, older retirees typically only experience a few major life transitions in the span of decades – retirement itself, a major change in health, and the death of a spouse – while it’s younger clients who actually experience a steady stream of major life transitions that may necessitate a financial advisor, from getting a new job, to going back to school, starting a business, getting married (or getting divorced!), having children, and more.

And while younger clients may have less in the way of investments and assets, they still face substantial complexities when it comes to their cash flow itself, from how to transition from a dual-income household to a stay-at-home-parent (or back again) after the birth of a child or a decision to go back to school, merging finances during a marriage (or separating them again after a divorce), to adjusting spending while launching a business. Or simply engaging in strategies to increase income and job potential in the first place.

Which means, in the end, while the focus of financial planning may shift for next-generation clients – from monitoring the health of their assets to monitoring the health of their income instead – arguably younger clients don’t really have “simpler” financial advice needs in the first place. Instead, they have a different set of complex financial advice needs… and an even greater need for the cyclical and ongoing financial planning process in the first place, because of the pace and frequency of the life transitions that impact their financial situation throughout their 20s, 30s, and 40s!

How Divvying Up Household Financial Responsibility Impacts Financial Knowledge Over Time

April 10, 2019 07:04 am 0 Comments CATEGORY: General Planning

Financial knowledge plays an important role in enabling individuals to engage in good financial behavior. However, like other forms of knowledge, financial knowledge is subject to decay if we don’t apply and reinforce that knowledge regularly. While this may seem fairly obvious, the reality is that the many decisions we make – including the decision to retain (or delegate) responsibility for making financial decisions – may influence our development and retention of financial knowledge.

In this post, Derek Tharp – lead researcher at Kitces.com, and an assistant professor of finance at the University of Southern Maine – delves into the recent research on how financial knowledge may increase or decrease over time based on how a couple allocates responsibility for making financial decisions.

A recent study from Adrian Ward and John Lynch provides some interesting insights into how the divvying up of financial decisions among couples may influence financial decision making. Contrary to what many may expect, the authors found that the initial assignment of financial responsibility was not influenced by levels of financial knowledge at the beginning of the relationship. While this may seem counterintuitive, from an economic perspective, it is the individual with the comparative advantage (rather than the absolute advantage) that we would expect to take on a larger share of financial responsibility in an efficient outcome. For example, despite a CFO’s potential absolute advantage over a stay-at-home spouse’s financial knowledge, it may be the case that it is better for the household financially if the CFO focuses on their work rather than managing household finances. Because all households have limited time and resources, the reality is that some trade-offs in all areas of life are ultimately inevitable.

Long-term, the assignment of financial responsibility appears to influence financial knowledge, with spouses who take on 100% of the responsibility becoming most knowledgeable, whereas those who take on no financial responsibility (i.e., delegate those responsibilities to their partner) actually experience a reduction in their financial knowledge over time. Furthermore, while those who share responsibility do appear to each see modest knowledge gains with time, those gains are much smaller than the gains experienced by households with one member specializing in financial responsibility.

Overall, this finding has important implications, as it suggests that there is both risk and opportunity associated with sharing or delegating financial responsibility. On the one hand, those who delegate may benefit from the higher levels of knowledge gained by the specializing spouse. On the other hand, should the specializing spouse experience disability or premature death, a spouse with less financial knowledge than they may have had if they were involved in making financial decisions could be thrust into a role as a financial decision-maker without being prepared. Moreover, it’s possible that financial knowledge of those who delegate responsibilities to a financial advisor could similarly experience a decrease in financial knowledge over time. While this is not explored in Ward and Lynch’s study, it is nonetheless important for financial planners to help clients understand both the risks and rewards associated with divvying up responsibility between members of a household… and between a household and their financial advisor!

How The Tools Of Financial Therapy Can Improve The Delivery (And Follow-Thru) Of Financial Planning Advice

March 13, 2019 07:03 am 0 Comments CATEGORY: General Planning

The fundamental purpose of financial planning is to help clients make better financial decisions to achieve their financial goals – and hopefully to feel happy or empowered along the way by having made those decisions. Yet as most financial advisors know from experience, getting clients to make better decisions (and ones that they feel happy about) is not so easy in practice.

Clients do not always listen. Clients don’t always follow through on the advice they are given. And sometimes clients even do things that truly worry us, and actually endanger their financial health in the process. And unfortunately, there is remarkably little training on what financial advisors should actually do in such instances!

In this guest post, Meghaan Lurtz, our Senior Research Associate at Kitces.com, explores how the tools and techniques of Financial Therapy could be that research-based solution that financial planners may want to give some serious consideration to for training on how to deliver better advice that actually sticks, and to learn to better help clients actually help themselves. Perhaps even more so than the recently in-vogue Behavioral Finance research, which in practice is more focused on categorizing the problem behaviors that clients tend to express, than what financial advisors can and should actually do about it.

For instance, Financial Therapy utilizes techniques like Solution-Focused Therapy (SFT) to help clients figure out what skills they may already possess to overcome their own (financial) challenges. Financial Genograms provide a means to unearth clients’ financial family history and how the relationships around them may be influencing their money behaviors. And exercises like “What Do You Believe” help to unearth and explore money scripts that may cause clients to get stuck in a financial rut, as their sometimes subconscious limiting beliefs sabotage their ability to make good financial decisions.

Of course, the reality is that at some point, problematic financial behaviors cross the line from something that a financial planner can help with (even one trained in financial therapy techniques), into a bona fide psychological disorder that merits a referral to a qualified mental health professional. Nonetheless, a wide range of financial therapy tools and techniques can be applied by financial planners in their routine work with clients, in an effort to help ensure clients actually follow-through on the advisor’s recommendations, and the client’s own financial decisions and commitments.

And fortunately, with the rise of organizations like the Financial Therapy Association, and new educational programs like the Certified Financial Therapist (CFT) designation, there are more opportunities than ever for financial planners to explore the tools and techniques of financial therapy and how they can be applied in a financial planning context with clients!

Why Evolutionary Psychology May Be Better Than Behavioral Finance Research To Understand Financial Behaviors

January 16, 2019 07:07 am 0 Comments CATEGORY: General Planning

There’s no doubt behavioral finance research has had a tremendous influence on our general understanding of human behavior. From loss aversion, to choice architecture, to the “Bottom Dollar” effect, and more – behavioral finance research has enhanced both our understanding of real-world financial behaviors, and what financial advisors must watch out for while trying to assist their clients in making wise(r) financial decisions.

However, despite its tremendous influence, behavioral finance research leaves a lot to be desired. Most notably, while behavioral finance has taught us a lot about how people behave, it tells us very little about why we behave how we do – and understanding why we behave the way we do is important to ensuring that we understand the circumstances in which biases, heuristics, and other behavioral quirks may lead us astray (so that we can then avoid or manage those circumstances).

In this guest post, Dr. Derek Tharp – lead Researcher for Kitces.com, and an assistant professor of finance at the University of Southern Maine – examines the weakness of behavioral finance as a field, and why evolutionary psychology may likely grow to become a more useful framework for understanding how humans make financial decisions.

In essence, the “problem” with behavioral finance research is that it is largely atheoretical, functioning more as an ever-growing catalog of human behaviors which do not align with traditional assumptions of rational behavior. Of course, cataloging interesting behavioral phenomena is not inherently a bad thing to do, and there is tremendous value in the cataloging work that has been done. But the reality is that a mere catalog of interesting financial behaviors is less insightful than a true theoretical perspective, especially when it comes to providing any real insight about what individuals (or their advisors) should do about those problem behaviors.

By contrast, evolutionary psychology, which applies Darwinian evolutionary principles to human psychology, can not only provide a rationale for why we engage in behavior such financial behaviors as the endowment effect or hyperbolic discounting, but also insight into the conditions in which we are most inclined to be misled. Specifically, humans must be most concerned when a bias or heuristic was functionally useful within the environment in which our ancestors evolved, but is no longer as relevant within our modern world. Further, evolutionary psychology also provides insights into areas such as communication, positive psychology, and psychopathology, suggesting that evolutionary psychology has much to offer financial counselors and therapists as well.

Scarcity: How This Rather Innocuous Sounding Economics Concept Actually Impacts Decision-Making

January 2, 2019 02:12 pm 0 Comments CATEGORY: General Planning

The basic concept of “scarcity” is rather straightforward – when there isn’t enough of something, that resource is scarce, which may mean it’s something we can’t get, must pay more for, or must find an alternative to, given its scarcity.

Yet recent research finds that the concept of scarcity, and its impact on decisions, goes far beyond just the economic framing of how scarcity may impact price and the economic supply and demand curves. Instead, scarcity also appears to take a more direct toll on our brains themselves and impacts the ways we make decisions in the first place.

In this guest post, Senior Research Associate Meghaan Lurtz explores the recent research of Sendhil Mullainathan and Eldar Shafir on how scarcity can cause “tunneling,” which limits our ability to fully weigh the pros and cons of a decision and also a “bandwidth tax,” which makes it difficult to fully focus on anything when the weighty consequences of scarcity are looming.

And notably, their research finds that it’s more than just financial scarcity that can impact us. Scarcity of time can be similarly damaging to financial scarcity, and the toll that scarcity takes on the brain and our decision-making process is present both in the face of actual scarcity and even just perceived scarcity. In other words, if we think we don’t have enough, it can still impair our decision-making process… potentially leading to less favorable decisions that really do amplify scarcity. A perverse “scarcity trap” that can feed upon itself.

So what’s the alternative? Trying to find “slack,” whether by releasing time commitments or earning more money to actually reduce the objective amount of scarcity. Or trying to deliberately focus more on the times of abundance – even if they’re just moments – to give our brains a break from the toll that scarcity otherwise takes. Although in reality, even those facing near-term scarcity won’t necessarily be facing scarcity in the long run… which means often the best thing a financial advisor can do is simply to put a currently-scarce situation in a longer-term context, reducing the scarcity-induced tendency to tunnel only on the near-term, and setting the pathway for making better long-term financial decisions!

Why (Prudent) Spending Rates Matter More Than Savings Rates

September 5, 2018 07:05 am 0 Comments CATEGORY: General Planning

The media provides no shortage of articles giving recommendations of how much households should save to afford retirement, from rules of thumb like “save 10% to 15% of your annual income” to more detailed research studies providing "precise" savings guidelines based on age, income level, and targeted retirement income replacement rates. The caveat to all of these tools, though, is that they presume the household has flexible discretionary dollars available to save in the first place.

Yet in reality, most households struggle to save because there is no money left at the end of the month to save in the first place. Because technically their problem isn’t a savings rate that’s too low; it’s a spending rate that’s too high, in one or more categories, that is causing all of the available household income to be consumed before the end of the month is even reached!

And sadly, there is remarkably little guidance available to households about what a prudent spending rate should be in the first place. In some of the largest categories, which tend to be financed with debt – e.g., homes and automobiles – lender guidelines place some restriction on the maximum amount of spending in each of those key categories. With the caveat that lenders don’t lend based on what is prudent for the borrower, but what will result in a permissible level of defaults and losses for the lender. Or stated more simply, borrowing guidelines are based on what the lender believes will extract the maximal amount of interest with an acceptable level of defaults… despite the fact that many of those borrowers will be in over their heads and struggling just to make their repayments!

A somewhat better data set for households to evaluate the prudence of their spending comes from comparing an individual’s spending to the Consumer Expenditure Survey from the Bureau of Labor Statistics, which details what households spend in various categories, segmented by income level (as fixed expenses not surprisingly consume far more of a lower-income household’s budget than those with higher income levels).

Of course, comparing one’s spending by category to average spending rates (by income level) still doesn’t necessarily reveal what is prudent and what a household should spend, especially when recognizing that the national savings rate is already a dismally low 3.2% (which means comparing to CES data in the end simply compares to a national set of households that already are spending “too much” and not saving enough!).

Nonetheless, focusing on spending rates at least puts the focus back on what households can control – what they spend, and what they earn – rather than focusing on or criticizing a savings rate that ultimately is more a result of other decisions than a decision unto itself. And also helps to recognize that, for most middle-income households where spending is challenging, it is actually far better to focus on housing and transportation costs than trying to trim vacations, clothing, lattes and avocado toast from the budget.

But the question still remains: what is a prudent spending rate for typical household expenses, and how do you figure out what is or is not an appropriate amount to spend in the first place (that “lives within your means” and leaves an available dollar amount of savings left over)?

Determining The ROI Of Eliminating Private Mortgage Insurance (PMI) With Principal Prepayments

July 11, 2018 07:01 am 9 Comments CATEGORY: General Planning

Featured Image Pre-Payment of Mortgage To Eliminate PMI ROI

Saving up a "traditional" 20% down payment can be difficult for many individuals. As a result, many borrowers end up paying private mortgage insurance (PMI), in order to cover the lender's risk that the proceeds from foreclosing on a property would not be sufficient to cover the outstanding liability of a mortgage. On the one hand, PMI is therefore valuable to borrowers as it creates opportunities for homeownership for those that don't have enough cash saved up to put 20% down (it is effectively the "cost" of buying a home without a traditional down payment), but, at the same time, PMI can seem like an expensive drain on a borrower's cash flow, making it enticing to pay down the debt to eliminate the need to pay PMI.

In this guest post, Dr. Derek Tharp – a Kitces.com Researcher, and a recent Ph.D. graduate from the financial planning program at Kansas State University – examines how to determine the ROI from prepaying a mortgage to eliminate PMI, and finds that although the ROI can be high over short time horizons, the ROI from eliminating PMI over longer time horizons is often much lower.

PMI is generally required on a mortgage with a long-to-value (LTV) ratio of less than 80% (i.e., less than a 20% down payment). Because PMI is actually a form of insurance for the lender rather than the borrower, the reality is that PMI is functionally the same as a higher interest loan taken out on whatever amount would be needed to be prepaid in order to reduce the LTV ratio to less than 80%. For instance, if a borrower pays $1,200 per year in PMI premiums for a $200,000 home with a 5% down payment, then the borrower is initially paying an effective $1,200 of interest on a loan equal to the additional 15% ($30k) that would be needed to be prepaid in order to avoid PMI. Which is not an insignificant amount of interest, as $1,200 of annual interest on a $30,000 loan is effectively 4% loan on top off whatever the underlying interest rate is. So, if a borrower is paying 4.5% on a mortgage, then the total cost of the additional "loan" (PMI) is roughly 8.5%. Further, since this assumed $1,200 premium does not reduce as the balance needed to get below 80% LTV declines, the cost of keeping this "loan" in place increases with time. For instance, a borrower paying $1,200 per year in PMI on a mortgage that is only $5,000 away from eliminating PMI is effectively paying a rate of 24% on top off whatever their underlying mortgage rate is!

However, this 8.5% only represents a short-term ROI over a single year time period, and a key consideration in determining the long-term ROI of an investment is the rate at which it can be reinvested. Since pre-payment of a mortgage is effectively "reinvested" in a stable investment that "only" earns an ROI equivalent to the mortgage rate itself, this creates a long-term drag on the ROI from prepaying a mortgage (as funds are then tied up in debt repayment rather than investments which may have a higher long-term expected returns). And over long enough ROI time horizons (e.g., 30-years), the ROI of eliminating PMI effectively approaches the same ROI as prepaying the mortgage itself (albeit slightly higher due to some benefit that remains from the initially higher ROI). Which is important to acknowledge because while PMI elimination can look highly attractive based off of a single year ROI, failure to appreciate the differing short-term and long-term ROIs can lead investors to make pre-payment decisions which may not align with their long-term goals.

Of course, pre-payment of a mortgage to eliminate PMI may still be an attractive investment (particularly on a risk-adjusted basis), but the reality is that the time horizon used to evaluate the decision has a substantial impact on the long-term ROI. And given that it is the long-term impact that is most important for investors to consider, deciding whether to eliminate PMI may not be as much of a "no-brainer" as simply calculating the single year ROI may lead us to believe!