Looks like we have several parallel threads in this frugal living thread.
Originally Posted by makeinu
I'm not interested in the probability of this event. I'm interested in the risk of loss (the probability multiplied by the money invested). No matter how small the probability of the event is, the risk can be made significant by increasing the size of the investment. For most people, a year's worth of housing expenses is a relatively sizable investment.
If you're saving the money you would have spent on a car and living frugally in other areas and putting
it in conservative investments you'll have much more than a year of housing saved. If someone only
has a year of rent payment saved up it might be pretty scary to dump it on a landlord in one shot.
What you call "risk of loss" is what some fund managers call VAR- value at risk. Sometimes for
things like stocks they estimate a probability density function for the fluctuations in value and compute
an expected loss. With the rent prepayment we're dealing with subjective probabilities. By sizing up
the landlord or management company you get a feeling for how to deal with them. Sitting here at the
computer I can't recall one that was so bad that I wouldn't suggest the pre payment deal.
Also, your landlord skipping town isn't the only thing you have to worry about. What if you need to skip town due to an emergency? Even if you could get the money back at a later date, I would think that having it available would be a godsend for whatever emergency compelled you to leave in the first place.
Originally Posted by makeinu
Comparing investments at different risk levels is not a simple matter. That's why fund managers make a lot of money. That's also why I prefer to invest in FDIC insured accounts. I figure my time is better spent saving/earning money elsewhere than analyzing my exposure to risk and my expected returns.
All I'm looking for is recognition that you can't directly compare your rate of return from prepayment with your rate of return in an FDIC insured savings account (and I would hope that no one is investing their monthly housing money in anything more risky than an FDIC insured account). I'm not saying it's a bad idea to do the prepayment. In fact, I will most definitely be mentioning it next time I'm negotiating a lease, thanks to you. But when I mention it I'll be sure to keep in mind the additional risk involved (perhaps I would get renter's insurance to hedge some of the risk...but of course that would eat into my discount).
You expect a higher rate of return for a riskier investment right? I figure that the before tax rate of
return for a one year rent prepayment with 7% discount is %20 using a 15% tax rate to make it
comparable with a mutual fund dividend. Once a frugal liver saves a sizeable chunk of money he or she
should put it in non-correlated risk categories. Once you start doing that you are naturally comparing
safe low risk with more risky investments. The first step in comparing different expected cash flows
is to make them comparable. Computing an annualized rate of return is one of them. When you have
the cash flows layed out you can then look at probabilities of loss. As I recall the leases I've made the
issue of lease breaking is covered- you're responsible for the total amount except as noted. A lawyer friend tells me that you can negotiate terms of a lease just like any contract. I suppose he means within limits imposed by law. It occurred to me that as long as you're negotiating a payment schedule you could put something in the lease about getting your money back if the place becomes uninhabitable. Wiith the people I dealt with it just seemed too improbable to worry about.
I analyze this transaction like it is a bond, I compute a periodic rate of return then annualize it to make it comparable with other options. I attached a zipped Excel spreadsheet with the layout.