Getting Your Interest
Stocks are the rock stars of the investment world. They tend to have the eye-popping returns - both negative and positive - and are usually the featured story in the business news. Nonetheless, interest-paying investments like bonds, mortgages, certificates of deposit, annuity contracts, and bank accounts are more important quantitatively and therefore, managing the interest-bearing portion of your financial activities is just as meaningful as making wise equity investments.
Interest-bearing securities are all about borrowing and lending. If you buy a bond, make a deposit in a bank or savings institution, or hold a balance in a money market fund, you are lending. If you take out a mortgage, purchase an appliance with a credit card, or are paying off your car over 48 months, you are borrowing. Interest rates are just the price of borrowing and the return to lending. Financial intermediaries such a banks, brokers, money market funds, and bond mutual funds organize these markets and they make money by charging borrowers more than they pay lenders.
There is no such thing as "the interest rate." There are hundreds, even thousands, of interest rates. The rate of a loan depends on the creditworthiness of the borrower. It also depends on whether the loan is collateralized. And it depends on the length and size of the loan plus a number of other factors. The interest rate received by lenders depends on whether the returns are taxable or tax-exempt, the time to maturity of the loan, and whether the borrower has the ability to pay the loan off early at specific prices. If the loan contract has desirable features from the point of view of the lender - such as being short-term, tax-exempt, or non-callable - then the interest rate tends to be lower. But if on the other hand the loan has undesirable features, those will be capitalized in the market into a higher interest rate.
Interest rates compensate the lender both for the time that the money was borrowed and, under normal inflationary circumstances, for the fact that the repayment will be made with dollars of less purchasing power. Economists divide the stated or nominal interest rate into two parts - the real (inflation adjusted) interest rate and the rate of inflation. High nominal interest rates don't necessarily correspond to high real rates. A perfect example of this was the late 1970s when both nominal interest rates and inflation were high. In 1979, the average yield on 3-month Treasury bills was 10.04%. The average rate of inflation between 1978 and 1979 was 11.3%. Since prices were going up faster than the nominal rate on T-bills, the real rate of return to savers was negative.
Here are a few tips on managing your money. First, repaying money that you have borrowed is a smart investment because you are earning whatever interest rate is being charged. Second, as a lender you should recognize that very long-term loans are quite risky. If you invest in a bond mutual fund, read the prospectus to determine the maturity structure of its investments.
Third, you should keep in mind that most interest income is taxable at your full marginal tax rate. Dividends got a break in the 2003 tax bill; interest did not. If you are investing in bonds or bond mutual funds with a maturity structure of more than three or four years, you should consider municipal bonds as an alternative to taxable corporate bonds since after-tax rates seem to be higher for munis in this maturity.
Managing your lending and borrowing activity is part of a good financial plan. After all, you are looking after your own interest!
* * * * *
Interest-bearing securities are all about borrowing and lending. If you buy a bond, make a deposit in a bank or savings institution, or hold a balance in a money market fund, you are lending. If you take out a mortgage, purchase an appliance with a credit card, or are paying off your car over 48 months, you are borrowing. Interest rates are just the price of borrowing and the return to lending. Financial intermediaries such a banks, brokers, money market funds, and bond mutual funds organize these markets and they make money by charging borrowers more than they pay lenders.
There is no such thing as "the interest rate." There are hundreds, even thousands, of interest rates. The rate of a loan depends on the creditworthiness of the borrower. It also depends on whether the loan is collateralized. And it depends on the length and size of the loan plus a number of other factors. The interest rate received by lenders depends on whether the returns are taxable or tax-exempt, the time to maturity of the loan, and whether the borrower has the ability to pay the loan off early at specific prices. If the loan contract has desirable features from the point of view of the lender - such as being short-term, tax-exempt, or non-callable - then the interest rate tends to be lower. But if on the other hand the loan has undesirable features, those will be capitalized in the market into a higher interest rate.
Interest rates compensate the lender both for the time that the money was borrowed and, under normal inflationary circumstances, for the fact that the repayment will be made with dollars of less purchasing power. Economists divide the stated or nominal interest rate into two parts - the real (inflation adjusted) interest rate and the rate of inflation. High nominal interest rates don't necessarily correspond to high real rates. A perfect example of this was the late 1970s when both nominal interest rates and inflation were high. In 1979, the average yield on 3-month Treasury bills was 10.04%. The average rate of inflation between 1978 and 1979 was 11.3%. Since prices were going up faster than the nominal rate on T-bills, the real rate of return to savers was negative.
Here are a few tips on managing your money. First, repaying money that you have borrowed is a smart investment because you are earning whatever interest rate is being charged. Second, as a lender you should recognize that very long-term loans are quite risky. If you invest in a bond mutual fund, read the prospectus to determine the maturity structure of its investments.
Third, you should keep in mind that most interest income is taxable at your full marginal tax rate. Dividends got a break in the 2003 tax bill; interest did not. If you are investing in bonds or bond mutual funds with a maturity structure of more than three or four years, you should consider municipal bonds as an alternative to taxable corporate bonds since after-tax rates seem to be higher for munis in this maturity.
Managing your lending and borrowing activity is part of a good financial plan. After all, you are looking after your own interest!
* * * * *
posted by Bob Moser at
8:58 PM
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