When you are looking for attractive financial investments, remember also to consider the return you get if you pay down your debts, especially if the interest you are paying on your debts is not fully deductible on your income tax return. An article in Parade Magazine (11-1-98) made the following statements:
Paying off the balance on a credit card is just about the best ‘investment’ you can ever make. Not having to pay 18% or 22% interest on a credit card is as good as earning 18% or 22%. Risk-free. Tax-free.
Where on earth can you possibly earn a guaranteed, tax-free, 18% return on your money? The stock market sometimes goes up 18% – but it sometimes goes down 18%. And whatever it does, the profits and dividends you do earn are subject to tax.
Likewise, a publication by the Office of Investor Education and Advocacy, an agency of the SEC, stated, “[T]here is no investment strategy anywhere that pays off as well as, or with less risk than, merely paying off all high interest debt you may have.”
In making your decision, be sure to calculate the returns of all the investment alternatives on an aftertax basis, to reflect the quirks of the income tax laws. For a particular investment to be a better choice than simply paying down a debt, the aftertax return on the investment needs to be higher than the aftertax cost of the interest on the debt. The following two examples should help to illustrate this.
|Example A(Credit Card)||Example B(Mortgage)|
|1. Interest rate on current debt||18%||7%|
|2. Marginal combined federal and state income tax ratea||22%||22%|
|3. Percent of interest expense deductible for income taxes||0%||100%|
|Then:Aftertax cost of interest on current debtb||18%||5.5%|
a) Tax rate on each additional dollar of taxable income
b) Line #1 minus (Line #1 times Line #2 times Line #3)
In Example A, an aftertax return of more than 18% is necessary for an investment to be more attractive than paying off the credit card, but in Example B, the aftertax return needs to exceed only 5.5% for an investment to be relatively more attractive than paying off the home mortgage. However, keep in mind that how much you will save by paying off your mortgage early is a sure thing, whereas how much you will actually earn on most investments is highly uncertain. Furthermore, paying off your mortgage before you retire should be a high priority goal.
When you are comparing the various alternatives, a very important consideration is knowing your marginal combined federal and state income tax rate. Many people don’t realize that their marginal combined income tax rate is 22% or less.
In most cases, financial advisors would suggest investing the maximum possible in an employer’s retirement savings plan (such as a 401k) and in either a regular or a Roth IRA, before making extra payments on a mortgage.
It is important that you stay informed about income tax laws regarding not only interest income investments, but also regarding other types of investments, because it is the aftertax return of an investment that is the critical consideration when comparing the returns of investment alternatives. For example, prior to the most recent changes in the capital gains tax laws, long-term capital gains had very little tax advantage over interest income; i.e., both were taxed at similar rates. As a result, investments that have potential to appreciate in price, but which pay little or no income, were relatively less attractive than they are now that income tax rates on capital gains are generally well below the tax rates on taxable interest income.
Also, give consideration to the historical returns of interest income investments versus common stocks. Historically, over periods of 20 years or longer, the annual returns on high-grade bonds have averaged considerably less than those on common stocks — from an average of almost three percentage points less to an average of more than seven percentage points less, depending upon the specific 20-year period. And on an aftertax basis, the differences were even greater for bonds with taxable interest payments.
Generally, over periods of 20 years or longer, those who invest in any type of interest income investment sacrifice the potential for significantly higher returns that they may earn if they invest a substantial portion of their investment portfolio in individual common stocks or in common stock mutual funds. Furthermore, according to an article in The Wall Street Journal (1-25-90), “Investment advisors say, all-bond portfolios can be just as risky as all-stocks – and occasionally even more volatile.”
If interest rates rise from the level at which you purchased any type of interest income investment, you will be earning a lower interest rate than what is available at that time to investors who purchase interest income investments similar to those you own. If your interest income investment is marketable (i.e., if it can be bought and sold by investors in one of the markets for interest income securities), its market value will adjust to the level needed to provide a competitive return. As a result, the price of your interest income investment will be lower than when you purchased it, so if you want to sell it before it matures, you will have to sell it at a loss.
The following example illustrates what happens to a marketable interest income investment when interest rates rise:
· You purchase a bond for $10,000 (its face amount) that has a 12-year maturity and provides an interest yield of 7% ($700 annually).
· During the next two years, interest rates rise to 8% for similar types of bonds with similar time remaining before they mature (i.e., about 10 years).
The price of your bond is likely to decline to about $9,325. This is calculated by discounting at 8% both (a) the face amount of the bond, and (b) the bond interest that will be paid during the next 10 years, and then adding these two amounts together.
The longer the remaining life of a marketable interest income investment like a bond, the greater will be its downside risk when interest rates are rising. (When interest rates are declining, the opposite will be true; i.e., the greater will be the potential increase in the price of your marketable interest income investment.) To mitigate the degree of exposure to both rising interest rates and declining interest rates, it would be wise to diversify the maturities on your interest income investments.
Another reason to diversify the maturities of your interest income investments is to improve liquidity. If you have an emergency, you may need a portion of the money you are planning to place in such investments. Therefore, it generally would be wise not to have that portion invested in an interest income investment with a maturity longer than a year. Then, if you withdraw that money before the investment matures, you will be able to do so without having to take a substantial loss, if any, on the principal. Usually, the longer the period before the investment matures, the greater will be the risk of substantial loss, if money is withdrawn early from that investment.
Let’s look at an example of a system called “laddering” that can be used to diversify the maturities of interest income investments.
· You have $55,000 to invest in interest income investments.
· You want no maturity longer than five years.
· You want $5,000 to be available now and another $5,000 that you can get quickly without significant loss of principal.
· The $5,000 that you want to be available now can be invested in a money-market type of investment, so there will be no early withdrawal penalties about which to be concerned.
· The remaining $50,000 can be invested in interest income investments for roughly the same amounts and whose maturities are at approximately equal intervals (e.g., quarterly, semi-annually, or annually) for up to five years. Thus, you could invest as follows:
(a) Approximately $10,000 in each of five investments that mature in each of five consecutive years,
(b) Approximately $5,000 in each of 10 investments that mature in each of 10 consecutive six-month periods, or
(c) Approximately $2,500 in each of 20 investments that mature in each of 20 consecutive quarters.
If you need to withdraw some money before an interest income investment matures, the one with the shortest maturity will usually be the most logical one to cash first. And if you don’t need to withdraw money after an interest income investment matures, you can reinvest the money for a period that will enable you to maintain your laddering schedule. This process can be repeated every time one of your interest income investments matures. As a result, you are likely to earn higher returns than you would by investing in shorter maturities, because longer maturities generally have higher interest rates than shorter maturities.
There is a wide selection of interest income investments from which to choose.
•Interest income investments offered by local banks, S&Ls, and perhaps credit unions are probably at least somewhat familiar to you. But you might also want to consider interest income investments offered by financial institutions located in other areas of the U.S., since some of them may offer higher rates than local financial institutions. You can compare interest rates on www.bankrate.com.
•Savings bonds now offer both fixed interest rates and rates that are indexed for inflation. The interest they pay is not subject to state income taxes, and federal income taxes can be deferred until the bonds are cashed. In certain cases where the interest is used to pay for higher education expenses, the interest may not be taxed at all.
•Bonds and other publicly traded interest income securities of the U.S. Government and its agencies may be attractive investments, especially for investors who want very high quality interest income securities and/or high liquidity for an investment of as little as $1,000, in some cases. Furthermore, the interest paid by these securities is not subject to state income taxes. And the rates paid by some publicly traded U.S. Government securities are indexed for inflation.
•Corporate interest income securities offer the widest range of interest rates. This is because of perceived differences in business risk among the various companies offering interest income securities. Some corporate bonds are as risky as, or riskier than, many common stocks.
•Tax-exempt interest income securities should be given consideration by investors in the highest income tax brackets. The primary attraction of such securities is the exemption from paying federal income taxes on the interest that is earned. And in North Carolina, no income tax is payable on interest on federally tax-exempt interest income securities issued by entities located within the state. However, if you may be subject to the Alternative Minimum Tax, check as to whether or not that tax is likely to apply to the specific tax-exempt interest income investments that you are considering purchasing.
•Zero-coupon bonds are offered in both the U.S. Government sector and the tax-exempt sector. Such bonds are similar to U.S. savings bonds, because they can be purchased at a fraction of their maturity value and there are no interest payments to reinvest. However, since no cash is paid until a zero-coupon bond matures, the investor will have to take money from another source to pay income taxes on the accrued interest that is earned, unless the bonds are tax exempt or they are held in a tax-deferred account, such as an IRA. Also, because a zero-coupon bond does not pay interest until maturity, its market price will decline more sharply than that of a conventional bond, when interest rates rise. This should not be a major concern, unless the bond needs to be sold before its maturity.