"guaranteed" 6% return vs index fund investing

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aussiedog
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"guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 9:43 am

Let me pose my question and then give some background below.

Question: If you had the option for a fixed 6% return on investment (with income as ordinary interest) vs just adding to index fund investing at current asset allocation, which would you choose?

Background: Family business has a variable rate bank loan that will likely be locked in soon, and partners in the business may have the opportunity to lend to the business at a fixed 6% rate. Business has been successful for the past 3 decades and has a low debt/equity ratio (~ 10%) so would likely be very low risk of defaulting on loan payments. But the interest income would be taxed as ordinary income (2017 we were in 33% federal, 9% state brackets) vs adding to index equity funds in our taxable account which would be taxed at capital gains rates.

The 'guaranteed' 6% return is attractive, and also could provide some diversification outside of stocks and bonds, but maybe the tax consequences are too negative? Thanks for any opinions.

Aussiedog

(Portfolio below for context)

=======================================================

Emergency funds: 12 months of expenses
Debt: 350K rental property mortgage @ 4.5%
Tax Filing Status: Married Filing Jointly
Tax Rate: 33% Federal, 9% State
State of Residence:Oregon
Age:54
Desired Asset allocation: 50% stocks / 50% bonds
Desired International allocation: 20% of stocks

Total portfolio low seven-figures., approximately 15% taxable and 85% tax advantaged
529's established and funded for 2 kids

Current retirement assets

Taxable
1% cash
7% Vanguard Total Stock Market Admiral VTSAX
3% Vanguard Total International Stock Admiral VTIAX
3% Vanguard Intermediate-Term Tax-Exempt Fund VWITX

His 403b
11% Total Bond Market Index Fund Signal Shares VBTSX

His 457
5% Fidelity 500 FXSIX
3% Fidelity sm cap VSCIX
3% Fidelity mid cap VMCIX

His IAP (state 401k-like pension account)
8% (composed of 45% public equity, 15% private equity, 25% fixed income, 15% real estate per manager- managed by state)

His TSP
16% G fund


His Roth IRA at Vanguard
5% Vanguard FTSE VFSVX

Her 403b
12% FXSIX Fidelity 500 Index
4% VTSNX Vanguard total international stock
3% VBTIX Vanguard total bond fund

Her 457
3% Vanguard total bond VBTSX

Her Roth IRA at Vanguard
6% REIT VGSLX

Real estate: Rental property:
7% equity in rental (wasn't sure how to list this)


Contributions

New annual Contributions
$24,000 to his 457
$24,000 to his TSP + %5 match
$6500 to his backdoor Roth IRA
$6500 to her backdoor Roth IRA
$24,000 to her 403b
$24,000 to her 457

His State Pension
His Federal Pension
(currently 20 years of service at each)

RadAudit
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Re: "guaranteed" 6% return vs index fund investing

Post by RadAudit » Sun Apr 15, 2018 9:54 am

Personal opinion: Anything that offers a rate of return significantly greater than a government backed CD probably has some risk somewhere. You might want to keep that in mind.
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BL
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Re: "guaranteed" 6% return vs index fund investing

Post by BL » Sun Apr 15, 2018 9:58 am

Just a couple comments:

Sounds like paying off/down the mortgage would give you a tax-free 4.5% return (yes, there are other considerations here).

What rate can they get from a bank loan?

For how long would the money be tied up? Is it lump sum or would you be adding to it regularly?
Last edited by BL on Sun Apr 15, 2018 10:03 am, edited 1 time in total.

Nate79
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Re: "guaranteed" 6% return vs index fund investing

Post by Nate79 » Sun Apr 15, 2018 10:00 am

I think you misunderstand the word guaranteed. Putting it in quotes doesn't make it any more correct.

msk
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Re: "guaranteed" 6% return vs index fund investing

Post by msk » Sun Apr 15, 2018 10:00 am

Strange. Why would a low debt business want to borrow at 6%? Surely the business can get better rates at a bank, even if floating. For many coming years.

dbr
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Re: "guaranteed" 6% return vs index fund investing

Post by dbr » Sun Apr 15, 2018 10:00 am

I would first need to know more about my (your) connection to the family business. It sounds like you are a partner so you must already have significant financial entanglement with the business.

It that is not the case and you are wondering how to trade off a 6% loan vs. investing the money in a 50/50 index fund portfolio I would say the basic answer is that the risk is too high to justify participating in the loan. But that is affected by how much. Throwing $10K that way is one thing; relying on half of all your assets in that loan would be foolish. Somewhere in between you might make sense. The point is that 6% is quite a bit higher yield than a bond mutual fund yields right now and it might, just might, be commensurate with the risk. I would also like to know more about the term of the loan and your ability to call it.

On the other hand, a simple answer would be to not touch this thing with a ten foot pole.

aristotelian
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Re: "guaranteed" 6% return vs index fund investing

Post by aristotelian » Sun Apr 15, 2018 10:04 am

The quotation marks around "guaranteed" are key. There is a non-zero chance of the business failing.

What is the term of the loan? Why do they need the money?

I would probably avoid mixing business and family regardless of perceived credit risk.

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dm200
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Re: "guaranteed" 6% return vs index fund investing

Post by dm200 » Sun Apr 15, 2018 10:09 am

This return is not "guaranteed" - and the principal is at some degree of risk.

Also, keep in mind (check with attorney) that "insiders" (such as those with any interest ownership) are at the end of the line for debt if there is a bankruptcy. That was an expensive lesson for me. This factor (in my opinion and experience) increases the risk of such a loan.
Last edited by dm200 on Sun Apr 15, 2018 10:11 am, edited 1 time in total.

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LiveSimple
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Re: "guaranteed" 6% return vs index fund investing

Post by LiveSimple » Sun Apr 15, 2018 10:11 am

Ask the question as “which is better, invest in
Diversified, federally governed public mutual index funds or in a private business, with a garantee to pay 6% ?”

Based on your involment the answer may vary ?

For me public mutual fund ? Unless the business owners are me and my wife.

Jack FFR1846
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Re: "guaranteed" 6% return vs index fund investing

Post by Jack FFR1846 » Sun Apr 15, 2018 10:15 am

I would personally much, much, much prefer to put the money into a 1.75% Redneck Bank Megamoney account. Or pay off the mortgage. I wouldn't do this business loan even at 20%.
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ofckrupke
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Re: "guaranteed" 6% return vs index fund investing

Post by ofckrupke » Sun Apr 15, 2018 11:15 am

On the family business loan, is the term fixed? Is it amortizing?
How liquid is it, can you call it at will? Xor only if the bank's willing to extend further credit under the existing rate and term? Can the business call your note at will? Where do you stand relative to prior, and any subsequent family creditors, and the bank, in precedence for claims against residual assets if the business folds?

WRT taxation of the 6% note's interest: as investment income it will be subject to the 3.8% NIIT; depending upon whether you fall into the new 24% xor the 32%, that makes the total tax cost 36.8% xor 44.8%.

The other thing is that between the security of your profession, and later income from FERS, PERS and RMDs from the deferred compensation plans and IAP (not enough years in any retirement gap to Rothify meaningfully), you are going to have a hell of a time spending down any of your taxable fortune in life. So if you haven't already, you should probably view it (less a current/emergency liquidity kitty) as legacy wealth - whether held as securities or as real assets. Viewed this way (with asset basis reset at succession) there is no deferred tax cost to amortize over a holding period for otherwise annually tax efficient equity assets. So the differential tax cost of the family loan really is 1-1/2 to 2%.

----

Respondent BL must have missed that your existing debt is on a rental property so the 4.5% return there would be pre-tax; after-tax in the mid-2 to 3.0% range depending upon your bracket under TJCA.

VBTSX has been replaced by VBTIX in his 403b and her 457.

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sperry8
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Re: "guaranteed" 6% return vs index fund investing

Post by sperry8 » Sun Apr 15, 2018 12:01 pm

6% taxed at ordinary income is 4% real (or thereabouts). I'd take my chances in the market (surely wouldn't mess with my equity portion). However, for my fixed income/cash AA portion, I'd allocate some of this to the business loan to diversify. Perhaps a third of my allocation.
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Pajamas
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Re: "guaranteed" 6% return vs index fund investing

Post by Pajamas » Sun Apr 15, 2018 12:08 pm

I would be concerned about the concentrated risk of both being a partner in a family firm and lending the business money. If you decide to do it anyway, consider investing only up to the point that if it all blows up, your other investments will be sufficient.

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Mel Lindauer
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Re: "guaranteed" 6% return vs index fund investing

Post by Mel Lindauer » Sun Apr 15, 2018 12:24 pm

Others have asked, but it hasn't been answered, so here goes again. Why does this business need the money? And why can't they get it at a lower rate from the bank?

Something doesn't make sense here.
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Re: "guaranteed" 6% return vs index fund investing

Post by tibbitts » Sun Apr 15, 2018 2:38 pm

I'd guess about 70% of Bogleheads would take 6% for life (with a U.S. government guarantee) and call it an investing career. Ironically that wouldn't have been true in the 80s or 90s, but would be today. The risk of course would be inflation. An inflation-adjusted 4%? Now you've got maybe 80%. A personal-inflation-adjusted 4%? 90%+.

This deal of course is worse than 6% from a junk bond fund, because it's junk but not diversified.

mega317
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Re: "guaranteed" 6% return vs index fund investing

Post by mega317 » Sun Apr 15, 2018 2:51 pm

Nothing like the word guarantee to pop a thread.
would likely be very low risk of defaulting
That's quite a qualifier.

This is basically a bond, I don't see how it diversifies.

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Re: "guaranteed" 6% return vs index fund investing

Post by Grt2bOutdoors » Sun Apr 15, 2018 3:00 pm

Equity is 90% at optimistic valuation.
Debt is currently 10%. With the additional lending, does the 10% remain the same or is this additional debt the business is taking on?
Problem here is two fold; when business sours, the equity valuation usually sours right along with it, a 10% D/E calculation might suddenly become a 50/50 or worse calculation. That is not something a bank would classify as "low risk" or "guaranteed". A guarantee is a loan backed by hard quantifiable assets that can be liquidated dollar for dollar, not 50 cents on the dollar in a liquidation event. 6% is not compensating you for the risk.
Banks are always willing to take a good credit risk - why aren't the business owners approaching the banks, or is it that they have but don't like the terms. Lots of questions with this that either has not been disclosed to you or that hasn't been asked. Whenever someone throws out a return figure that is somewhat juicier than can be obtained from a true AAA guaranteed loan made to the US treasury, one ought to look more closely and say "why me and what are the risks".
Last edited by Grt2bOutdoors on Sun Apr 15, 2018 3:13 pm, edited 1 time in total.
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aussiedog
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Re: "guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 3:07 pm

Sorry all, I have tried to reply twice but my posting didn't appear. Thanks for the feedback thus far. To try to answer questions:

1. The family business is a farm and my wife is a partner
2. The debt was from purchase of adjacent property to expand the farm--the business was nearly debt free previously and the debt from the land purchase constitutes less than 10% of the value of the farm
3. The (bank) loan from this debt is at a variable rate, now at 4.5%, and with interest rates rising there was consideration of fixing the rate, which I was told would be 6.5% from the current lender--I myself am not very up on loan rates and apparently this sounds very high to everyone.
4. There was a proposal (I don't have details yet) that partners might have the option to essentially loan the business some or all of the debt at a 6% rate. That was what prompted my post. My assumption was that such a loan would be low risk because of the long term stability of the business and the substantial equity relative to minimal debt and few creditors, making default on the loan unlikely, even in the event of catastrophic business failure.

But I agree certainly that
-it may or may not be a good investment if taxed as ordinary income (relative to other options)
-we would be putting more eggs in one basket, given the existing fractional ownership of the farm
-I had also thought about (but don't know the answer to) the liquidity of such an arrangement, which could be a limitation relative to other options

Grt2bOutdoors
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Re: "guaranteed" 6% return vs index fund investing

Post by Grt2bOutdoors » Sun Apr 15, 2018 3:19 pm

aussiedog wrote:
Sun Apr 15, 2018 3:07 pm
Sorry all, I have tried to reply twice but my posting didn't appear. Thanks for the feedback thus far. To try to answer questions:

1. The family business is a farm and my wife is a partner
2. The debt was from purchase of adjacent property to expand the farm--the business was nearly debt free previously and the debt from the land purchase constitutes less than 10% of the value of the farm
3. The (bank) loan from this debt is at a variable rate, now at 4.5%, and with interest rates rising there was consideration of fixing the rate, which I was told would be 6.5% from the current lender--I myself am not very up on loan rates and apparently this sounds very high to everyone.
4. There was a proposal (I don't have details yet) that partners might have the option to essentially loan the business some or all of the debt at a 6% rate. That was what prompted my post. My assumption was that such a loan would be low risk because of the long term stability of the business and the substantial equity relative to minimal debt and few creditors, making default on the loan unlikely, even in the event of catastrophic business failure.

But I agree certainly that
-it may or may not be a good investment if taxed as ordinary income (relative to other options)
-we would be putting more eggs in one basket, given the existing fractional ownership of the farm
-I had also thought about (but don't know the answer to) the liquidity of such an arrangement, which could be a limitation relative to other options
What is the term of the proposed loan - 1,3, or 5 years? It's a farm, I'm assuming you know what types of crops are grown and the current and forecasted near-term market for those crops. The bank is agreeing to fix the rate on a floating note, the cost to the farm is 2%, you pay them fixed, they pay floating to the funding market, if interest rates float up higher than 6.5% then the bank has to essentially "eat" it. The bank views the farming business not to be guaranteed and as risky. How risky? Here's an idea.....BBB investment grade bonds currently yielding 3.5% on average, highest yields are about 5% for 5 year debt, you are being quoted 6.5%.

A 2% spread to fix the rate is deemed to be expensive by the business, and yet, they are amenable to a 1.5% spread? Usually a 50bp spread should not make a huge difference unless the business would find itself hampered in making those P&I payments on a timely basis because cashflow is so unpredictable with farming and/or the size of the loan is large. What is the "out" for the lender (fractional owners) if they want their money back? it's easier for a bank - they can call the note but I don't believe the insiders will have such an option.

If you decide to move forward, don't lend anymore than would permit you to not sleep well at night anymore. Concentrating equity ownership and now debt with the same business is not diversifying.
Last edited by Grt2bOutdoors on Sun Apr 15, 2018 3:33 pm, edited 2 times in total.
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aussiedog
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Re: "guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 3:29 pm

What is the term of the proposed loan - 1,3, or 5 years? It's a farm, I'm assuming you know what types of crops are grown and the current and forecasted near-term market for those crops. A 2% spread to fix the rate is deemed to be expensive by the business, and yet, they are amenable to a 1.5% spread? Usually a 50bp spread should not make a huge difference unless the business would find itself hampered in making those P&I payments on a timely basis because cashflow is so unpredictable with farming and/or the size of the loan is large. What is the "out" for the lender (fractional owners) if they want their money back? it's easier for a bank - they can call the note but I don't believe the insiders will have such an option.
Grt2b and others: I have to plead ignorance on some of this--details are not yet known by me--the concept of the loan was raised and piqued my interest but much I still don't know about the terms of a proposed loan.

My understanding was not that a 2% spread was deemed expensive and 1.5% deemed acceptable, but rather that the 2% spread was being considered but an option for partners to provide the loan instead was being offered. Not sure where the 6% vs 6.5% difference came from. I expect that the terms of the proposed arrangement would be important, I just don't know them yet.

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Pajamas
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Re: "guaranteed" 6% return vs index fund investing

Post by Pajamas » Sun Apr 15, 2018 3:36 pm

Seems to me that if only some of the partners participated in a loan to the partnership at a below-market interest rate, the reduced interest would be subsidizing the overall return from the partnership to the benefit of the partners that did not participate in the loan. Might consider making it all-or-none or at least have everyone understand and agree to it unanimously.

aussiedog
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Re: "guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 3:45 pm

Pajamas, I think you are correct, though probably would be only a small subsidy to the other partners.

It is a family business with a small number of partners. I don't know for certain, but the thought may have been that a partner loan instead of bank could provide a small benefit to the business (6% rate instead of 6.5%) and provide a nice return for the loaning partners (6%), but this is just speculation on my part.

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Re: "guaranteed" 6% return vs index fund investing

Post by jminv » Sun Apr 15, 2018 3:48 pm

Debt increases the riskiness of a business and this is certainly not a guaranteed investment. You are also an insider of some sort so where would you be if this company defaulted - out of partnership equity plus out the amount you lent it? You're also increasing your concentrated risk. If the business and it's low debt level are actually attractive at an arm's length level, the business should be able to reach an agreement from a bank on the same or superior terms so why isn't it? I'd imagine it's because a bank wouldn't lend on the same terms you're willing to take which means you are not being paid for the risk you are taking.

You later say that maybe it would provide a small benefit to the business (6% instead of 6.5%) which further cements the notion that the people lending the business the money are not being compensated for the risk. The bank rate could easily be 8% or 10% and restrictive covenants. If the bank won't lend to this business at your rate and lack of covenants then you shouldn't either.

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Re: "guaranteed" 6% return vs index fund investing

Post by MotoTrojan » Sun Apr 15, 2018 3:50 pm

Decide on a representative time horizon and do the math on what expected return in a tax-efficient investment of similar risk would be (total US stock being what I’d compare to). I think you’re anchoring to the glory that 6% sounds like but in reality this is likely a much lower after-tax CAGR than equities.

dbr
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Re: "guaranteed" 6% return vs index fund investing

Post by dbr » Sun Apr 15, 2018 3:57 pm

This is a farm and presumably the equity is land. That would make quite a difference concerning the security of the loan. It isn't even clear if this is a loan to a business or putting up money to buy land. I think there is a lack of explanation for why this is a loan considering all the principals are partners and presumably actually own shares of the assets, the land, including the new acreage being purchased. Why is there a loan rather than just calling for the investment of more capital. What are the present arrangements for any partner to take income from the operation or to sell a share of the partnership.

I would think the decision to lend or not lend would depend hugely on how much money is involved as fraction of a person's assets. The decision would also depend on the period of the loan and whether or how it could be called.

aussiedog
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Re: "guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 4:00 pm

Decide on a representative time horizon and do the math on what expected return in a tax-efficient investment of similar risk would be (total US stock being what I’d compare to). I think you’re anchoring to the glory that 6% sounds like but in reality this is likely a much lower after-tax CAGR than equities.
Makes sense--it was the question I was trying to originally pose to the group--how people think these two (fixed 6% return vs index stock fund) compare.

I think I was anchoring more to the "known" "stable" 6% return, but given the tenor of most of the responses, I think I may be underestimating the risk. I was assuming that because there aren't other creditors ahead in line, and because the farm does have real estate assets, that parcels of land could be sold in the unlikely event that loan payments could not be made.

aussiedog
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Re: "guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 4:06 pm

It isn't even clear if this is a loan to a business or putting up money to buy land.
dbr: the land was purchased a few years ago, and at that time the partners decided to borrow to fund the purchase rather than investing more of their own capital. The loan has a variable rate, and the recent discussion came up as consideration was being given to fixing the loan rate in the setting of rising interest rates. Again, my understanding is that before doing this with the bank, there was discussion starting about allowing partners to loan some of the money if they were interested.

dbr
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Re: "guaranteed" 6% return vs index fund investing

Post by dbr » Sun Apr 15, 2018 4:18 pm

aussiedog wrote:
Sun Apr 15, 2018 4:06 pm
It isn't even clear if this is a loan to a business or putting up money to buy land.
dbr: the land was purchased a few years ago, and at that time the partners decided to borrow to fund the purchase rather than investing more of their own capital. The loan has a variable rate, and the recent discussion came up as consideration was being given to fixing the loan rate in the setting of rising interest rates. Again, my understanding is that before doing this with the bank, there was discussion starting about allowing partners to loan some of the money if they were interested.
Yes, but if your wife is a partner and she is loaning to the farm she is loaning to herself. That is the part I am confused on. Are you saying the partners are soliciting private loans to replace a bank loan but they themselves are not granting loans?

To try to answer your actual question I would not tangle up my assets with this kind of operation at an interest rate of 6%. If I wanted an expected return in the long run of that magnitude I would invest the money in question in a stock mutual fund. If I wanted that return in the short run I would not expect to get that from any investment, seemingly including this one as you don't mention any mechanism to certainly get the money back. Someone asked what the amortization schedule was but you don't seem to have one. If I had $1M to invest and this proposal was asking for $25K I would do it just to keep in with the family. If this proposal is asking for $250K out of my $1M I wouldn't even begin to consider it. As an aside what is the total equity your wife has in this venture? Also, the whole idea seems odd somehow.

aussiedog
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Re: "guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 4:26 pm

dbr: you may be picking up that I have limited experience in these matters or that I am inarticulate (or both!)

Let me try again:
1. The business has an existing variable rate loan from a bank and is considering fixing the loan rate via the same lender.

2. As an alternative to #1, I understood that they were considering letting partners extend the fixed rate loan instead (though I don't know any of the proposed terms).

Maybe this is an unusual thing to do (?). I just don't have much experience to know (hence my posting).

dbr
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Re: "guaranteed" 6% return vs index fund investing

Post by dbr » Sun Apr 15, 2018 4:45 pm

aussiedog wrote:
Sun Apr 15, 2018 4:26 pm
dbr: you may be picking up that I have limited experience in these matters or that I am inarticulate (or both!)

Let me try again:
1. The business has an existing variable rate loan from a bank and is considering fixing the loan rate via the same lender.

2. As an alternative to #1, I understood that they were considering letting partners extend the fixed rate loan instead (though I don't know any of the proposed terms).

Maybe this is an unusual thing to do (?). I just don't have much experience to know (hence my posting).
I had best bail out here. I don't understand the concept of the partners in effect loaning money to themselves. Can anyone else explain this?

My answer to the original question is unchanged. I would put this money in a stock index fund before I would get it mixed up in this partnership.

I was also going to ask if your wife is a partner why are they coming to you for a loan? What does she think of this as presumably your finances are also hers.

aussiedog
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Re: "guaranteed" 6% return vs index fund investing

Post by aussiedog » Sun Apr 15, 2018 6:42 pm

Fair enough, maybe it doesn't really make a lot of sense. I was posting for my wife and myself--they weren't coming to me for a loan, but potentially making available to us as an option.

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