Technical analysis is the study of how securities prices behave and how to exploit that information to make money while avoiding losses. The technical style of trading is opportunistic. Your immediate goal is to forecast the price of the security over some future time horizon in order to buy and sell the security to make a cash profit. The future time frame is unknown at the beginning of a trade, but it's not "forever" — as it may be with buy-and-hold investing. The emphasis in technical analysis is to make profits from trading, not to consider owning a security as some kind of savings vehicle. Therefore, technical analysis dictates a more active trading style than you may be used to.
Trading or investing: The many faces of technical analysis
Both traders and investors use technical analysis. What's the difference between a traderand an investor?
A trader holds securities for a short period of time.
An investor holds securities for a long time.
Okay, what's the difference between these holding periods?
A short holding period is anywhere from one minute to one year.
A long holding period is anywhere from six months to forever, depending on who you ask.
Notice that the holding period of the trader and the investor overlap. Actually, the dividing line between trader and investor isn't fixed (except for purposes of taxation).
You can use technical methods over any investment horizon, including the long-term. If you're an expert in Blue Widget stock, for example, you can add to your holdings when the price is relatively low, take some partial profit when the price is relatively high, and dump it all if the stock crashes. Technical analysis has a tool for identifying each of these situations. You can also use technical tools to rotate your capital among a number of securities depending on which ones are delivering the highest gains these days. At the other end of the investment horizon spectrum, you can use technical analysis to spot a high-probability trade, and execute the purchase and sale in the space of an hour.
Setting new rules
You may have the idea that because technical analysis entails an active trading style, you're about to embark on a wild and risk-laden adventure. Nothing could be further from the truth. Executing the one-hour trade has less inherent risk of loss than buying and holding a security indefinitely, without an exit plan, based on some expert's judgment of its value.
Preventing and controlling losses is more important to practically every technical trader you meet than outright profit-seeking. The technical analysis approach is demonstrably more risk-averse than the value-investing approach.
That's because to embrace technical analysis is to embrace a way of thinking that's always sensitive to risk. Technical trading means to trade with a plan that identifies the potential gain and the potential loss of every trade ahead of time. The technical trader devises rules for dealing with price developments as they occur in order to realize the plan. In fact, you select your technical tools (from the many available) specifically to match your trading style with your sensitivity to risk.
Using rules, especially rules to control losses, is the key feature of long-term success in trading. Anybody can get lucky — once. To make profits consistently requires you not only to identify the trading opportunity, but also to manage the risk of the trade. Most of the "trading rules" that you hear about, such as "Cut your losses and let your winners run," arise from the experience of technical traders.
Making the case for managing the trade
To buy and hold securities for a very long period of time is a well-documented path to accumulating capital, but only if your timing is good — you're lucky enough to buy the security when its price is rising. If your timing isn't so hot or you're unlucky, it's a different story all together. Consider the following:
If you had bought U.S. stocks at the price peak just ahead of the 1929 Crash, it would've taken you 22 years to get back your initial capital.
Since the end of World War II, the Dow Jones Industrial Average has fallen by more than 20 percent on 11 occasions.
More recently, from January 2000 to October 2002, the S&P 500 fell by 50 percent. If you owned all the stocks in the S&P 500 and held them throughout the entire period, you lost 50 percent of your stake, which means you now need to make a gain equivalent to 100 percent of your starting capital to get your money back, as Table 1 shows. Ask yourself how often anyone makes a 100 percent return on investment.
Table 1: Recovering a Loss
Loss
Gain Needed to Recover Loss
10%
11.1%
20%
25.0%
30%
42.9%
40%
66.7%
50%
100.0%
60%
150.0%
75%
300.0%
Timing your entry and exit from the market is critical to making money and controlling losses
5.23.2008
Getting Loans
Sometimes, it may seem as though lenders are trying to give away money by making credit so easily available. But this is a dangerous illusion. When it comes to consumer debt (credit cards, auto loans, and the like), lenders aren't giving away anything except the opportunity for you to get in over your head, rack up high interest charges, and delay your progress toward your financial and personal goals.
Credit is most dangerous when you make consumption purchases that you couldn't afford in the first place.
Nevertheless, there are times when you need to borrow: to buy a house, to pay for college, to start your own business, to pay unexpected medical expenses, and sometimes to give in to the temptation to purchase something you've always wanted. The way you get a loan is by establishing creditworthiness. You are deemed worthy of credit if you have sufficient assets to repay the loan and if you have a good history of loan-repayment, based on your credit report. If your record of repayment is poor, you'll either be denied the loan, have to pay higher-than-normal interest charges (interest rates vary depending on the nature of the loan, the loan agency, and the health of the nation's economy), or, depending on the purpose of the loan, you may qualify for government assistance.
All loans are either secured or unsecured.
The most common items purchased by a secured loan are houses, cars, household furnishings, and jewelry. Unsecured loans include loans to pay credit card debt, college expenses, vacation costs, and medical bills. Because unsecured loans are riskier for lenders, most of these loans have higher interest rates than secured loans do, usually representing the biggest drain on your finances.
Before you ask for a loan, be sure that your loan payments won't strain your budget. Try to make extra payments on the loan or pay it off early if there are no penalties to do so. If practical, consider a home equity loan as you can usually get a lower interest rate and the interest is tax deductible. Just be certain you can make the payments, as your home is at risk if you can't.
You can get loans from your bank, savings and loan, credit union, and a host of vendors and other agencies with money to lend.
Credit is most dangerous when you make consumption purchases that you couldn't afford in the first place.
Nevertheless, there are times when you need to borrow: to buy a house, to pay for college, to start your own business, to pay unexpected medical expenses, and sometimes to give in to the temptation to purchase something you've always wanted. The way you get a loan is by establishing creditworthiness. You are deemed worthy of credit if you have sufficient assets to repay the loan and if you have a good history of loan-repayment, based on your credit report. If your record of repayment is poor, you'll either be denied the loan, have to pay higher-than-normal interest charges (interest rates vary depending on the nature of the loan, the loan agency, and the health of the nation's economy), or, depending on the purpose of the loan, you may qualify for government assistance.
All loans are either secured or unsecured.
The most common items purchased by a secured loan are houses, cars, household furnishings, and jewelry. Unsecured loans include loans to pay credit card debt, college expenses, vacation costs, and medical bills. Because unsecured loans are riskier for lenders, most of these loans have higher interest rates than secured loans do, usually representing the biggest drain on your finances.
Before you ask for a loan, be sure that your loan payments won't strain your budget. Try to make extra payments on the loan or pay it off early if there are no penalties to do so. If practical, consider a home equity loan as you can usually get a lower interest rate and the interest is tax deductible. Just be certain you can make the payments, as your home is at risk if you can't.
You can get loans from your bank, savings and loan, credit union, and a host of vendors and other agencies with money to lend.
5.19.2008
The Ins and Outs of Figuring Loan Interest
Pretty much everyone knows that interest is the extra amount you have to pay to a lender in addition to paying back the amount you borrow. But most people (even some experienced business managers) are not entirely clear regarding how interest is figured. When you borrow money, you agree to a method of interest accounting, whether you understand the method or not.
Suppose someone offers to loan you $100,000 for one year, and he tells you that he will charge you 6 percent interest. How much will you have to pay him one year from today? He does mean 6 percent per year, right? Certainly he doesn't mean 6 percent per month. Whatever agreement he's offering, get it in writing.
When you take out a loan, the lender should ask you to sign a legal instrument called a note. This document states the principal of the loan ($100,000), the maturity date (one year from the present date), the interest rate per period (6 percent per year), and other provisions concerning my rights as a lender in the event that you default — that is, if you don't comply fully with the conditions of the loan. The lender may ask for collateral, or security for the loan, which generally is an asset you own that the lender could take possession of and sell to pay off your debt in the event you default. Or he may ask for a lien to be filed on property you own as security for the loan (which is done in mortgage loans). The lender may require a co-signer — a second person who signs the note and is liable for the debt if you default.
How much do you owe on this loan one year later? The lender wants his money back ($100,000) plus 6 percent of the principal, which is $6,000 interest. So you owe him $106,000 at the maturity date of the loan. You had the use of $100,000 for one year and pay $6,000 in interest for that privilege. The lender gave up the use of the money for one year and earned $6,000 interest income.
Say that you need the money for two years instead of one. Because of the longer time period, the lender might demand a higher interest rate, say 6.5 percent. At the end of the first year you pay him $6,500 interest, and at the end of the second year you pay him $106,500, which consists of $6,500 interest for the second year and the $100,000 payoff of the principal.
Changing the example ever so slightly can have profound implications. Suppose that you need to borrow $100,000 for two years and you agree to pay 6.5 percent annual interest. However, you don't want to make any interest payment until the maturity date, which is two years later. How much do you owe then? The 6.5 percent interest rate is based on the premise that the lender receive interest at the end of each year. If that doesn't happen the first year, the nonpayment of interest becomes a loan within a loan; you have to pay 6.5 percent interest on this "second loan" in addition to the original $100,000 loan principal. The principal balance at the start of the second year, therefore, is $106,500. The lender's entitled to 6.5 percent interest on the $106,500 principal balance during the second year. Obviously, the interest for the second year will be more than the interest owed for the first year.
This adding on, or bumping up, of the principal balance of a loan because of the nonpayment of interest at the end of the period is called compounding, or compound interest. The balance owed is compounded by the amount of the unpaid interest, and this higher balance is the basis for computing interest during the next period. (This term also applies when you are on the receiving end of interest, such as when you invest money in a savings account.) In the example of the two-year loan, the interest for the second year, based on the compounded balance brought forward from the end of the first year, is:
$106,500 Principal Balance x 6.5% Interest Rate = $6,922.50 Second Year Interest
What if you borrowed the money for five years, with no interest payments along the way? How much would you owe at the end of five years (assuming the lender's willing to make the loan for five years with no interest payments until maturity)? You would owe $137,000 (rounded off a little) at the end of the fifth year, for a total of $37,000 interest. How do you know whether this is correct? You could trust the lender; after all, he's in the business of loaning money and he ought to know what he's doing. But it may be better to calculate whether the amount of interest seems in the ballpark. Without compounding, the interest would be $6,500 per year (based on the original $100,000 borrowed), and for five years this would be $32,500 total interest. The extra $4,500 interest that the lender says that you owe at the end of five years because of compounding seems reasonable. Of course, you could ask your accountant to double-check the number, or you could use a handheld calculator to do so.
Suppose someone offers to loan you $100,000 for one year, and he tells you that he will charge you 6 percent interest. How much will you have to pay him one year from today? He does mean 6 percent per year, right? Certainly he doesn't mean 6 percent per month. Whatever agreement he's offering, get it in writing.
When you take out a loan, the lender should ask you to sign a legal instrument called a note. This document states the principal of the loan ($100,000), the maturity date (one year from the present date), the interest rate per period (6 percent per year), and other provisions concerning my rights as a lender in the event that you default — that is, if you don't comply fully with the conditions of the loan. The lender may ask for collateral, or security for the loan, which generally is an asset you own that the lender could take possession of and sell to pay off your debt in the event you default. Or he may ask for a lien to be filed on property you own as security for the loan (which is done in mortgage loans). The lender may require a co-signer — a second person who signs the note and is liable for the debt if you default.
How much do you owe on this loan one year later? The lender wants his money back ($100,000) plus 6 percent of the principal, which is $6,000 interest. So you owe him $106,000 at the maturity date of the loan. You had the use of $100,000 for one year and pay $6,000 in interest for that privilege. The lender gave up the use of the money for one year and earned $6,000 interest income.
Say that you need the money for two years instead of one. Because of the longer time period, the lender might demand a higher interest rate, say 6.5 percent. At the end of the first year you pay him $6,500 interest, and at the end of the second year you pay him $106,500, which consists of $6,500 interest for the second year and the $100,000 payoff of the principal.
Changing the example ever so slightly can have profound implications. Suppose that you need to borrow $100,000 for two years and you agree to pay 6.5 percent annual interest. However, you don't want to make any interest payment until the maturity date, which is two years later. How much do you owe then? The 6.5 percent interest rate is based on the premise that the lender receive interest at the end of each year. If that doesn't happen the first year, the nonpayment of interest becomes a loan within a loan; you have to pay 6.5 percent interest on this "second loan" in addition to the original $100,000 loan principal. The principal balance at the start of the second year, therefore, is $106,500. The lender's entitled to 6.5 percent interest on the $106,500 principal balance during the second year. Obviously, the interest for the second year will be more than the interest owed for the first year.
This adding on, or bumping up, of the principal balance of a loan because of the nonpayment of interest at the end of the period is called compounding, or compound interest. The balance owed is compounded by the amount of the unpaid interest, and this higher balance is the basis for computing interest during the next period. (This term also applies when you are on the receiving end of interest, such as when you invest money in a savings account.) In the example of the two-year loan, the interest for the second year, based on the compounded balance brought forward from the end of the first year, is:
$106,500 Principal Balance x 6.5% Interest Rate = $6,922.50 Second Year Interest
What if you borrowed the money for five years, with no interest payments along the way? How much would you owe at the end of five years (assuming the lender's willing to make the loan for five years with no interest payments until maturity)? You would owe $137,000 (rounded off a little) at the end of the fifth year, for a total of $37,000 interest. How do you know whether this is correct? You could trust the lender; after all, he's in the business of loaning money and he ought to know what he's doing. But it may be better to calculate whether the amount of interest seems in the ballpark. Without compounding, the interest would be $6,500 per year (based on the original $100,000 borrowed), and for five years this would be $32,500 total interest. The extra $4,500 interest that the lender says that you owe at the end of five years because of compounding seems reasonable. Of course, you could ask your accountant to double-check the number, or you could use a handheld calculator to do so.
Calculating Home Mortgage Interest
The biggest loan in most individuals' financial lives is a home mortgage. In contrast to a short-term auto loan, a home mortgage loan can run out to 30 years, and the amount borrowed is usually much larger than for an automobile.
Suppose that you recently bought the home of your dreams and qualified for a $250,000 mortgage loan for 30 years at a 6 percent annual interest rate. The loan requires monthly payments, so you divide the annual interest rate by 12 to determine the monthly rate, which is 0.5 percent (or 1/2 of 1 percent) per month. In almost all cases the monthly payments over the life of a mortgage loan are equal and uniform. Assuming uniform payments over the 30-year life of the loan, how much would each of your 360 loan payments be? How do you determine this amount? You probably would assume that the lender's quoted amount is correct — and you'd be pretty safe in this assumption. But how can you be sure?
You can use a relatively inexpensive business/financial calculator to quickly determine monthly loan payments. These handy tools have special keys for entering each of the variables of a loan. To determine the monthly payment in this example, pull out your trusty calculator and enter the following numbers for each variable:
N = number of periods — 360 months in this example
INT = interest rate per period — 0.5 percent per month in this example. (These calculators assume that interest is a percentage, so type .5, not .005.)
PV = present value, or amount borrowed today (the present time) — $250,000 in this example
FV = future value, or principal amount owed after the final monthly loan payment is made — $0 in this example. (This means that the loan is fully paid off after the last monthly loan payment; otherwise, you enter the amount of the balloon payment due at the end of the loan.)
PMT = payment per period based on the four numbers just entered — $1,498.88 in this example. (This is the amount you solve for, which appears as a negative number, meaning that you have to pay this amount per month.)
The big advantage of using a business/financial calculator is that you can enter the known numbers (the first four) and then simply hit the button for the unknown number, which appears instantly. Another big advantage is that you can keep these numbers in the calculator and make "what if" changes very quickly. For example, what if the annual interest rate were 4.8 percent? Just reenter the new interest rate (0.4 percent per month) and then call up the new monthly payment amount, which is $1,311.66. The monthly payment difference times 360 payments is $67,396.65 less interest over the life of the loan. It definitely pays to shop around for a lower rate.
If you use the Internet, you can find many Web sites that provide online financial calculators. You can go to one of the popular Web search engines, such as Yahoo or Google, and type "financial calculator" in the search bar. From the list you get, select one that seems to fit your needs. Also, Microsoft Excel and other spreadsheet programs include a financial function for calculating the monthly payment for a mortgage. The old-fashioned method — before handheld calculators and personal computers came along — was to use printed tables that give the factors for different interest rates and time periods per $1,000. Surprisingly, many people still use these tables, and accounting and finance textbooks still include them. Old habits die hard.
Each mortgage payment is divided between interest for the month and principal amortization, which refers to the reduction of the loan balance. For the first month of our example, the interest amount is $1,250 ($250,000 loan balance x 0.5 percent monthly interest rate = $1,250). Therefore, the first month's principal reduction is only $248.88. Right off, you can see that the loan's principal balance will go down slowly — and that a 30-year mortgage loan involves a lot of interest. Lenders provide you with a loan payoff (amortization) schedule. Take a look, although trying to follow down a table of 360 rows of monthly payments is tedious.
Suppose that you recently bought the home of your dreams and qualified for a $250,000 mortgage loan for 30 years at a 6 percent annual interest rate. The loan requires monthly payments, so you divide the annual interest rate by 12 to determine the monthly rate, which is 0.5 percent (or 1/2 of 1 percent) per month. In almost all cases the monthly payments over the life of a mortgage loan are equal and uniform. Assuming uniform payments over the 30-year life of the loan, how much would each of your 360 loan payments be? How do you determine this amount? You probably would assume that the lender's quoted amount is correct — and you'd be pretty safe in this assumption. But how can you be sure?
You can use a relatively inexpensive business/financial calculator to quickly determine monthly loan payments. These handy tools have special keys for entering each of the variables of a loan. To determine the monthly payment in this example, pull out your trusty calculator and enter the following numbers for each variable:
N = number of periods — 360 months in this example
INT = interest rate per period — 0.5 percent per month in this example. (These calculators assume that interest is a percentage, so type .5, not .005.)
PV = present value, or amount borrowed today (the present time) — $250,000 in this example
FV = future value, or principal amount owed after the final monthly loan payment is made — $0 in this example. (This means that the loan is fully paid off after the last monthly loan payment; otherwise, you enter the amount of the balloon payment due at the end of the loan.)
PMT = payment per period based on the four numbers just entered — $1,498.88 in this example. (This is the amount you solve for, which appears as a negative number, meaning that you have to pay this amount per month.)
The big advantage of using a business/financial calculator is that you can enter the known numbers (the first four) and then simply hit the button for the unknown number, which appears instantly. Another big advantage is that you can keep these numbers in the calculator and make "what if" changes very quickly. For example, what if the annual interest rate were 4.8 percent? Just reenter the new interest rate (0.4 percent per month) and then call up the new monthly payment amount, which is $1,311.66. The monthly payment difference times 360 payments is $67,396.65 less interest over the life of the loan. It definitely pays to shop around for a lower rate.
If you use the Internet, you can find many Web sites that provide online financial calculators. You can go to one of the popular Web search engines, such as Yahoo or Google, and type "financial calculator" in the search bar. From the list you get, select one that seems to fit your needs. Also, Microsoft Excel and other spreadsheet programs include a financial function for calculating the monthly payment for a mortgage. The old-fashioned method — before handheld calculators and personal computers came along — was to use printed tables that give the factors for different interest rates and time periods per $1,000. Surprisingly, many people still use these tables, and accounting and finance textbooks still include them. Old habits die hard.
Each mortgage payment is divided between interest for the month and principal amortization, which refers to the reduction of the loan balance. For the first month of our example, the interest amount is $1,250 ($250,000 loan balance x 0.5 percent monthly interest rate = $1,250). Therefore, the first month's principal reduction is only $248.88. Right off, you can see that the loan's principal balance will go down slowly — and that a 30-year mortgage loan involves a lot of interest. Lenders provide you with a loan payoff (amortization) schedule. Take a look, although trying to follow down a table of 360 rows of monthly payments is tedious.
Distinguishing Between Types of Credit
You may think that all credit is created equal. Lots of people think so, which is one of many reasons they run into debt problems. They definitely aren't created equal, and you should get familiar with these terms so you can become a better credit consumer.
Here are the types of credit you should be familiar with:
Secured: With this kind of credit, the creditor guarantees that it will be paid back by putting a lien on an asset you own. The lien entitles the creditor to take the asset if you don't live up to the terms of your credit agreement. Car loans, mortgages, and home equity loans are common types of secured credit.
Unsecured: When your credit is unsecured, you simply give your word to the creditor that you will repay what you borrow. Credit card, medical, and utilities bills are all examples of unsecured credit.
Revolving: If your credit is revolving, the creditor has approved you for a set amount -- your credit limit -- and you can access the credit whenever you want and as often as you want. In return, you must pay the creditor at least a minimum amount on your account's outstanding balance each month. Credit cards and home equity lines of credit are examples of revolving credit.
Installment: With installment credit, you borrow a certain amount of money for a set period of time and you repay the money by making a series of fixed or installment payments. Examples of installment credit include mortgages, car loans, and student loans.
Here are the types of credit you should be familiar with:
Secured: With this kind of credit, the creditor guarantees that it will be paid back by putting a lien on an asset you own. The lien entitles the creditor to take the asset if you don't live up to the terms of your credit agreement. Car loans, mortgages, and home equity loans are common types of secured credit.
Unsecured: When your credit is unsecured, you simply give your word to the creditor that you will repay what you borrow. Credit card, medical, and utilities bills are all examples of unsecured credit.
Revolving: If your credit is revolving, the creditor has approved you for a set amount -- your credit limit -- and you can access the credit whenever you want and as often as you want. In return, you must pay the creditor at least a minimum amount on your account's outstanding balance each month. Credit cards and home equity lines of credit are examples of revolving credit.
Installment: With installment credit, you borrow a certain amount of money for a set period of time and you repay the money by making a series of fixed or installment payments. Examples of installment credit include mortgages, car loans, and student loans.
Buying Life Insurance
You buy life insurance so that your death will not burden your loved ones financially — house payments will be made, groceries will be on the table, and college dreams can be realized.
Keep these pointers in mind as you buy life insurance:
If both you and your spouse work, then cover both incomes.
Cover the homemaker for the amount you would need to hire an outside service to perform the homemaker's functions.
Buy coverage of at least 6 to 7.5 times your current income. Add to this amount for final expenses and college costs.
Buy term life insurance, in most cases. Buy cash-value permanent insurance only if your need is permanent.
Keep these pointers in mind as you buy life insurance:
If both you and your spouse work, then cover both incomes.
Cover the homemaker for the amount you would need to hire an outside service to perform the homemaker's functions.
Buy coverage of at least 6 to 7.5 times your current income. Add to this amount for final expenses and college costs.
Buy term life insurance, in most cases. Buy cash-value permanent insurance only if your need is permanent.
5.18.2008
Buying a Replacement Car: New or Used?
How satisfied are you with your present vehicle? Unless additional safety features, increased fuel economy, or other compelling reasons really justify the cost of a newer model — or you're sick of driving the same old workhorse year after year — repairing a good older vehicle and continuing to drive it is often a wiser move. If you decide to replace your old car, you face another decision: whether to buy a new vehicle or a used one. Each option offers advantages and disadvantages, so keep an open mind until you have all the facts.
The advantages of buying new
The allure of new cars is certainly compelling: shiny paint in myriad rainbow colors; gadgets and doodads that blink and glow; and who can resist that new car smell? But there are more — and better — reasons than these to consider a new car.
Safety features
The best reason for buying a new vehicle is to replace one that lacks such vital safety features as air bags, integrated child seats, structural reinforcements and the like.
Other technological improvements
In recent years, innovations in steering and suspension, fuel injection, and basic equipment have resulted in vehicles that get better gas mileage, run cleaner, and can go for long periods of time between tune-ups and other periodic maintenance.
You don't have to worry about past problems/neglect/repairs
It's nice to have a car that's all your own, free of the mistakes, mishaps, and poor choices of a previous owner. It should be pristine, rarin' to go, and free of the battle scars and aging components that can plague an older vehicle. Of course, some new cars have problems of their own due to faulty manufacturing or newfangled systems that may succumb to unforeseen circumstances. The choice of risks is yours. However, there's no denying that a new car is often considered more attractive and prestigious than an older model from the same manufacturer. You pay your money and you take your chances.
The advantages of buying used
Although owning a brand-new car is nice, there are many reasons to buy a good used vehicle rather than a new one.
Used vehicles cost less to own and maintain
Consumer Federation of America spokesperson and author Jack Gillis advises that "buying a used car will reduce your ownership and operating expenses by about 50 percent." Perhaps the best proof of this is that, currently, the average age of vehicles in the United States is nine years — the highest in half a century. And if that's not enough to sway you, consider the following tidbits of financial fodder:
Registration, licensing fees, and insurance premiums for new cars are much higher than for used cars.
When you buy a used car, you don't have destination, "dealer prep," and shipping costs to pay.
You can keep a well-made vehicle running beautifully for a lot less than you'd spend on new-car payments, fees, and premiums, even if you rebuild the engine or restore the body.
In addition to the fact that new cars can depreciate 30 percent to 40 percent in only two years, buying or leasing a new vehicle can continue to cost you several hundred dollars a month for an average of three years. As one Consumer Reports Buying Guide put it, "A new car depreciates 20 to 30 percent the minute you drive it off the dealer's lot." Why not buy a two- or three-year-old used vehicle and let some other hotshot take the loss?
A well-built automobile that has been properly maintained can stay on the road for over 150,000 miles, even though most of us think our cars are played out at half that mileage.
Used cars can be classics
While new cars devaluate, many older cars are gaining in value and prestige. Some of us view cars as works of art and dream about owning a really classic piece of automotive engineering. If you're in the market for a status symbol, it may be wiser (and more impressive) to forget about the new luxury models and look for an older classic car instead. The same holds true if you consider your car an investment and not just a machine to move you and your brood from here to there and back again.
Such oldies increase in value because they're beautifully made — in many cases, by hand. And, although their owners usually love and pamper classic vehicles, in the long run, rust and accidents cause the supply to diminish and the value of the surviving ones to increase.
The advantages of buying new
The allure of new cars is certainly compelling: shiny paint in myriad rainbow colors; gadgets and doodads that blink and glow; and who can resist that new car smell? But there are more — and better — reasons than these to consider a new car.
Safety features
The best reason for buying a new vehicle is to replace one that lacks such vital safety features as air bags, integrated child seats, structural reinforcements and the like.
Other technological improvements
In recent years, innovations in steering and suspension, fuel injection, and basic equipment have resulted in vehicles that get better gas mileage, run cleaner, and can go for long periods of time between tune-ups and other periodic maintenance.
You don't have to worry about past problems/neglect/repairs
It's nice to have a car that's all your own, free of the mistakes, mishaps, and poor choices of a previous owner. It should be pristine, rarin' to go, and free of the battle scars and aging components that can plague an older vehicle. Of course, some new cars have problems of their own due to faulty manufacturing or newfangled systems that may succumb to unforeseen circumstances. The choice of risks is yours. However, there's no denying that a new car is often considered more attractive and prestigious than an older model from the same manufacturer. You pay your money and you take your chances.
The advantages of buying used
Although owning a brand-new car is nice, there are many reasons to buy a good used vehicle rather than a new one.
Used vehicles cost less to own and maintain
Consumer Federation of America spokesperson and author Jack Gillis advises that "buying a used car will reduce your ownership and operating expenses by about 50 percent." Perhaps the best proof of this is that, currently, the average age of vehicles in the United States is nine years — the highest in half a century. And if that's not enough to sway you, consider the following tidbits of financial fodder:
Registration, licensing fees, and insurance premiums for new cars are much higher than for used cars.
When you buy a used car, you don't have destination, "dealer prep," and shipping costs to pay.
You can keep a well-made vehicle running beautifully for a lot less than you'd spend on new-car payments, fees, and premiums, even if you rebuild the engine or restore the body.
In addition to the fact that new cars can depreciate 30 percent to 40 percent in only two years, buying or leasing a new vehicle can continue to cost you several hundred dollars a month for an average of three years. As one Consumer Reports Buying Guide put it, "A new car depreciates 20 to 30 percent the minute you drive it off the dealer's lot." Why not buy a two- or three-year-old used vehicle and let some other hotshot take the loss?
A well-built automobile that has been properly maintained can stay on the road for over 150,000 miles, even though most of us think our cars are played out at half that mileage.
Used cars can be classics
While new cars devaluate, many older cars are gaining in value and prestige. Some of us view cars as works of art and dream about owning a really classic piece of automotive engineering. If you're in the market for a status symbol, it may be wiser (and more impressive) to forget about the new luxury models and look for an older classic car instead. The same holds true if you consider your car an investment and not just a machine to move you and your brood from here to there and back again.
Such oldies increase in value because they're beautifully made — in many cases, by hand. And, although their owners usually love and pamper classic vehicles, in the long run, rust and accidents cause the supply to diminish and the value of the surviving ones to increase.
Car Buying: Before Getting a Lease or Loan
Your three major alternatives when acquiring a vehicle are leasing it, financing it with a loan, or using your own cash to pay for it. Of course, when you pay for a car with your own cash, you're not beholden to any person or institution. However, if you lease or borrow, keep the following information in mind.
Depreciation is a major factor
When deciding whether to finance a new vehicle with a lease or loan, keep in mind that the cost of a lease or loan is partially determined by the vehicle's rate of depreciation (or how much value the vehicle loses as it grows older) during the duration of the contract. For this reason, make sure that you know how much the vehicle you want will depreciate over the first two or three years you own it.
A new vehicle usually depreciates from 30 to 50 percent in the first three years in the United States, and an average of 2 percent per month in Canada. For this reason, you may decide to let someone else absorb the depreciation by selecting a 2- or 3-year-old, previously owned vehicle rather than a new one.
Also, the higher the purchase price, the more you'll continue to pay for licensing, registration, insurance, taxes, and interest. Be sure you understand how depreciation affects these arrangements and how you may end up paying for depreciation twice.
Credit or leasing companies require insurance
When you lease a car or purchase one with a loan, the lessor or the creditor can stipulate the kind of insurance you must get for your car. However, according to the AAA (American Automobile Association), although a credit or leasing company can require you to insure the vehicle for fire, theft, collision, and so on, it cannot force you to purchase a policy through a specific broker, agent, or company.
Look for the best coverage you can find before agreeing to purchase insurance through a dealer or financer, the person responsible for financing a lease or loan. If you decide to insure through one of these sources, do not let them include the insurance premiums in the cost of the lease or loan. If you do, you have to pay interest on your coverage.
You may need more than one type of insurance if you choose to finance a vehicle. You may consider getting some of the following types of insurance, for example:
Auto insurance coverage: Financer-required insurance usually does not include any minimum liability insurance that your state or province requires, or anything else besides comprehensive and collision coverage to repair or replace the vehicle if it is damaged or stolen. Verify that all insurance policies are in effect before you take possession of the vehicle.
GAP insurance: This type of insurance covers the difference between a vehicle's stated value in a finance contract and what an insurance company will pay if the vehicle is damaged beyond repair or stolen before the end of the finance period or lease. Some financing contracts provide GAP insurance free of charge; others include it as part of the up-front cost (the total amount you have to pay before you can drive a vehicle off the lot), and still others require you to purchase the insurance yourself. Although GAP insurance shouldn't cost more than a couple of hundred dollars, some policies can be much more expensive — especially if they're obtained through the financer.
Because a vehicle begins to depreciate as soon as you take possession of it, its replacement value soon may be substantially less than when you bought it, and your insurance policy may not cover the full amount that you'll have to come up with to compensate the financer, if the need arises.
Credit life or credit disability insurance: These policies make your payments if you die or become disabled while your financing is still in effect. This coverage is usually optional and extremely overpriced. If you feel that your estate could not cover the payments in the event of your death, you can buy this type of insurance at a better price from an outside source.
Some credit unions supply this insurance at no charge because the rules in many unions specify that loan obligations be canceled in the event of death. Because unscrupulous financers sometimes slip this coverage in whether you want it or not, be smart and recalculate the monthly payment shown on the final contract to be sure they do not include this coverage as a hidden charge.
Manufacturer's rebates and financing offers
Car manufacturers with their own financing departments may offer lower interest rates on loans and leases than rates that are available from outside credit sources. To ensure goodwill, some pay the security deposit and first monthly payment when you lease the next car from them after a previous lease contract with them expires. Others offer perks such as free maintenance, auto club and towing services, emergency hotlines, stolen-vehicle tracking, and other goodies. Generally speaking, the more expensive the vehicle, the greater the perks offered by the manufacturer.
Auto manufacturers run frequent promotions that offer you the choice between a rebate or a low-interest deal. Ask your accountant or a friend who's good with numbers to work out which alternative would be the most profitable arrangement for you.
If you go for the rebate, ask the dealer to base the sales or lease contract on the price of the vehicle after the rebate has been deducted, instead of writing the contract for the original price and mailing you the rebate later on. Doing this enables you to avoid paying higher taxes,interest, registration fees, and perhaps insurance, on the pre-rebate price of the vehicle, which may be a couple of thousand dollars more than the vehicle actually costs you.
Depreciation is a major factor
When deciding whether to finance a new vehicle with a lease or loan, keep in mind that the cost of a lease or loan is partially determined by the vehicle's rate of depreciation (or how much value the vehicle loses as it grows older) during the duration of the contract. For this reason, make sure that you know how much the vehicle you want will depreciate over the first two or three years you own it.
A new vehicle usually depreciates from 30 to 50 percent in the first three years in the United States, and an average of 2 percent per month in Canada. For this reason, you may decide to let someone else absorb the depreciation by selecting a 2- or 3-year-old, previously owned vehicle rather than a new one.
Also, the higher the purchase price, the more you'll continue to pay for licensing, registration, insurance, taxes, and interest. Be sure you understand how depreciation affects these arrangements and how you may end up paying for depreciation twice.
Credit or leasing companies require insurance
When you lease a car or purchase one with a loan, the lessor or the creditor can stipulate the kind of insurance you must get for your car. However, according to the AAA (American Automobile Association), although a credit or leasing company can require you to insure the vehicle for fire, theft, collision, and so on, it cannot force you to purchase a policy through a specific broker, agent, or company.
Look for the best coverage you can find before agreeing to purchase insurance through a dealer or financer, the person responsible for financing a lease or loan. If you decide to insure through one of these sources, do not let them include the insurance premiums in the cost of the lease or loan. If you do, you have to pay interest on your coverage.
You may need more than one type of insurance if you choose to finance a vehicle. You may consider getting some of the following types of insurance, for example:
Auto insurance coverage: Financer-required insurance usually does not include any minimum liability insurance that your state or province requires, or anything else besides comprehensive and collision coverage to repair or replace the vehicle if it is damaged or stolen. Verify that all insurance policies are in effect before you take possession of the vehicle.
GAP insurance: This type of insurance covers the difference between a vehicle's stated value in a finance contract and what an insurance company will pay if the vehicle is damaged beyond repair or stolen before the end of the finance period or lease. Some financing contracts provide GAP insurance free of charge; others include it as part of the up-front cost (the total amount you have to pay before you can drive a vehicle off the lot), and still others require you to purchase the insurance yourself. Although GAP insurance shouldn't cost more than a couple of hundred dollars, some policies can be much more expensive — especially if they're obtained through the financer.
Because a vehicle begins to depreciate as soon as you take possession of it, its replacement value soon may be substantially less than when you bought it, and your insurance policy may not cover the full amount that you'll have to come up with to compensate the financer, if the need arises.
Credit life or credit disability insurance: These policies make your payments if you die or become disabled while your financing is still in effect. This coverage is usually optional and extremely overpriced. If you feel that your estate could not cover the payments in the event of your death, you can buy this type of insurance at a better price from an outside source.
Some credit unions supply this insurance at no charge because the rules in many unions specify that loan obligations be canceled in the event of death. Because unscrupulous financers sometimes slip this coverage in whether you want it or not, be smart and recalculate the monthly payment shown on the final contract to be sure they do not include this coverage as a hidden charge.
Manufacturer's rebates and financing offers
Car manufacturers with their own financing departments may offer lower interest rates on loans and leases than rates that are available from outside credit sources. To ensure goodwill, some pay the security deposit and first monthly payment when you lease the next car from them after a previous lease contract with them expires. Others offer perks such as free maintenance, auto club and towing services, emergency hotlines, stolen-vehicle tracking, and other goodies. Generally speaking, the more expensive the vehicle, the greater the perks offered by the manufacturer.
Auto manufacturers run frequent promotions that offer you the choice between a rebate or a low-interest deal. Ask your accountant or a friend who's good with numbers to work out which alternative would be the most profitable arrangement for you.
If you go for the rebate, ask the dealer to base the sales or lease contract on the price of the vehicle after the rebate has been deducted, instead of writing the contract for the original price and mailing you the rebate later on. Doing this enables you to avoid paying higher taxes,interest, registration fees, and perhaps insurance, on the pre-rebate price of the vehicle, which may be a couple of thousand dollars more than the vehicle actually costs you.
Understanding Auto Insurance
Over the course of your life, you may spend tens of thousands of dollars on auto insurance, but are you spending it where it's most needed? Look for the following important features when searching for an auto insurance policy.
Bodily injury/property damage liability
As with homeowner's liability insurance, auto liability insurance provides insurance against lawsuits. Especially in a car, accidents happen. Make sure that you have enough bodily injury liability insurance to cover your assets. (Coverage of double your assets is preferable.)
If you're just beginning to accumulate assets, don't mistakenly assume that you don't need liability protection. Many states require a minimum amount — insurers can fill you in on the details for your state.
Property damage liability insurance covers damage done by your car to other people's cars and property. The amount of property damage liability coverage in an auto insurance policy is usually determined as a consequence of the bodily injury amount selected. $50,000 is a good minimum to start with.
Uninsured or underinsured motorist liability
When you are in an accident with another motorist and he doesn't carry his own liability protection or doesn't carry enough, uninsured or underinsured motorist liability coverage allows you to collect for lost wages, medical expenses, and pain and suffering incurred in the accident.
Should you already have comprehensive health and long-term disability insurance, then uninsured or underinsured motorist liability coverage is largely redundant. You do give up the ability to sue for general pain and suffering if you drop this coverage and to insure passengers in your car who may lack adequate medical and disability coverage.
Deductibles
To keep your auto insurance premiums down and to eliminate the need to file small claims, take the highest deductibles you're comfortable with (most people should consider $500 to $1,000). On an auto policy, two deductibles exist:
Collision applies to claims arising from collisions (note that you can generally bypass collision coverage when you rent a car if you have collision coverage on your own policy).
Comprehensive applies to other claims for damages not caused by collision (for example, a window broken by vandals).
As your car ages and is worth less, you can eventually eliminate your comprehensive and collision coverages altogether. The point at which you do this is up to you. Remember that the purpose of insurance is to compensate you for losses that are financially catastrophic to you. Insurers won't pay more than the book value of your car, regardless of what it costs to repair or replace it.
Special discounts
You may be eligible for special discounts on auto insurance. Don't forget to tell your agent or insurer if your car has a security alarm, air bags, or antilock brakes. If you're older or have other policies or cars insured with the same insurer, you may also qualify for discounts. And make sure that you're given appropriate "good driver" discounts if you've been accident- and ticket-free in recent years.
And here's another idea: Before you buy your next car, call insurers and ask for insurance quotes for the different models that you're considering. The cost of insuring a car should factor into your decision as to which car you buy because the insurance costs will be a major portion of your car's ongoing operating expenses.
Little-stuff coverage to skip
Auto insurers have dreamed up all sorts of riders, such as towing and rental car reimbursement. On the surface, these riders appear to be inexpensive. But the riders are expensive given the little that you'd collect from a claim plus the hassle of filing.
Riders that waive the deductible under certain circumstances make no sense, either. The point of the deductible is to reduce your policy cost and the hassle of filing small claims.
Medical payments coverage typically pays a few thousand dollars for medical expenses. If you and your passengers carry major medical insurance coverage, this rider isn't really necessary. Besides, a few thousand dollars of medical coverage doesn't protect you against catastrophic expenses.
Roadside assistance, towing, and rental car reimbursement coverage will only pay small dollar amounts and aren't worth buying. In fact, if you belong to an automobile club, you may already have some of these coverages.
Where to buy auto insurance
To obtain quotes for auto insurance, compare any of the following major providers that may be in your area:
Amica
GEICO
Liberty Mutual
Nationwide Mutual
State Farm
Progressive
Coping with teen drivers
If you have a teenage driver in your household, in addition to worrying a lot more, you are going to be spending a lot more on auto insurance. Best parental advice: Keep your teenager out of your car as long as possible.
If you allow your teenager to drive, you can take a number of steps to avoid spending all of your take-home pay on auto insurance bills:
Make sure that your teen does well in school. Some insurers offer discounts if your child is a high-academic achiever and has successfully completed a nonrequired driver's education class.
Get price quotes from several insurers to see how adding your teen driver to your policy affects the cost.
Have your teenager share in the costs of using the car. If you pay all the insurance, gas, oil changing, and maintenance bills, your teenager won't value the privilege of using your "free" car.
Of course, letting teens drive shouldn't just be about keeping your insurance bills to a minimum. Auto accidents are the number one cause of death for teens. So, before you let your teen drive, be sure to educate him or her about the big risks of driving and the importance of not riding in a car driven by someone who is intoxicated. Also be sure that your teens drive in safe cars.
Bodily injury/property damage liability
As with homeowner's liability insurance, auto liability insurance provides insurance against lawsuits. Especially in a car, accidents happen. Make sure that you have enough bodily injury liability insurance to cover your assets. (Coverage of double your assets is preferable.)
If you're just beginning to accumulate assets, don't mistakenly assume that you don't need liability protection. Many states require a minimum amount — insurers can fill you in on the details for your state.
Property damage liability insurance covers damage done by your car to other people's cars and property. The amount of property damage liability coverage in an auto insurance policy is usually determined as a consequence of the bodily injury amount selected. $50,000 is a good minimum to start with.
Uninsured or underinsured motorist liability
When you are in an accident with another motorist and he doesn't carry his own liability protection or doesn't carry enough, uninsured or underinsured motorist liability coverage allows you to collect for lost wages, medical expenses, and pain and suffering incurred in the accident.
Should you already have comprehensive health and long-term disability insurance, then uninsured or underinsured motorist liability coverage is largely redundant. You do give up the ability to sue for general pain and suffering if you drop this coverage and to insure passengers in your car who may lack adequate medical and disability coverage.
Deductibles
To keep your auto insurance premiums down and to eliminate the need to file small claims, take the highest deductibles you're comfortable with (most people should consider $500 to $1,000). On an auto policy, two deductibles exist:
Collision applies to claims arising from collisions (note that you can generally bypass collision coverage when you rent a car if you have collision coverage on your own policy).
Comprehensive applies to other claims for damages not caused by collision (for example, a window broken by vandals).
As your car ages and is worth less, you can eventually eliminate your comprehensive and collision coverages altogether. The point at which you do this is up to you. Remember that the purpose of insurance is to compensate you for losses that are financially catastrophic to you. Insurers won't pay more than the book value of your car, regardless of what it costs to repair or replace it.
Special discounts
You may be eligible for special discounts on auto insurance. Don't forget to tell your agent or insurer if your car has a security alarm, air bags, or antilock brakes. If you're older or have other policies or cars insured with the same insurer, you may also qualify for discounts. And make sure that you're given appropriate "good driver" discounts if you've been accident- and ticket-free in recent years.
And here's another idea: Before you buy your next car, call insurers and ask for insurance quotes for the different models that you're considering. The cost of insuring a car should factor into your decision as to which car you buy because the insurance costs will be a major portion of your car's ongoing operating expenses.
Little-stuff coverage to skip
Auto insurers have dreamed up all sorts of riders, such as towing and rental car reimbursement. On the surface, these riders appear to be inexpensive. But the riders are expensive given the little that you'd collect from a claim plus the hassle of filing.
Riders that waive the deductible under certain circumstances make no sense, either. The point of the deductible is to reduce your policy cost and the hassle of filing small claims.
Medical payments coverage typically pays a few thousand dollars for medical expenses. If you and your passengers carry major medical insurance coverage, this rider isn't really necessary. Besides, a few thousand dollars of medical coverage doesn't protect you against catastrophic expenses.
Roadside assistance, towing, and rental car reimbursement coverage will only pay small dollar amounts and aren't worth buying. In fact, if you belong to an automobile club, you may already have some of these coverages.
Where to buy auto insurance
To obtain quotes for auto insurance, compare any of the following major providers that may be in your area:
Amica
GEICO
Liberty Mutual
Nationwide Mutual
State Farm
Progressive
Coping with teen drivers
If you have a teenage driver in your household, in addition to worrying a lot more, you are going to be spending a lot more on auto insurance. Best parental advice: Keep your teenager out of your car as long as possible.
If you allow your teenager to drive, you can take a number of steps to avoid spending all of your take-home pay on auto insurance bills:
Make sure that your teen does well in school. Some insurers offer discounts if your child is a high-academic achiever and has successfully completed a nonrequired driver's education class.
Get price quotes from several insurers to see how adding your teen driver to your policy affects the cost.
Have your teenager share in the costs of using the car. If you pay all the insurance, gas, oil changing, and maintenance bills, your teenager won't value the privilege of using your "free" car.
Of course, letting teens drive shouldn't just be about keeping your insurance bills to a minimum. Auto accidents are the number one cause of death for teens. So, before you let your teen drive, be sure to educate him or her about the big risks of driving and the importance of not riding in a car driven by someone who is intoxicated. Also be sure that your teens drive in safe cars.
5.16.2008
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Recording Bond Transactions with Microsoft Money
A bond is really a loan that you make to a government agency or private corporation. During the life of the loan, the government agency or corporation pays you interest, known as the coupon rate. Interest payments are usually made twice yearly. Bonds are considered safer investments than stocks because the amount of the bond is paid back at the end of the loan term, known as the maturity date. Instead of owning part of the company, which is the case with stocks, bondholders own a debt that the company or government agency that issued the bond is obliged to pay back.
Read on to find out how to track bond purchases and interest distributions with Money.
Recording the purchase of a bond
When you purchase a bond, follow these steps to record its purchase:
1. Click the Investing tab.
2. Click the Portfolio Manager link.
The Portfolio Manager window appears.
3. Click the Work with Investments link, and then choose Record a Buy on the drop-down menu.
The Edit Transaction dialog box appears.
4. On the Inv. Account drop-down menu, select the name of the investment or retirement account where you want to record the purchase of the bond.
5. In the Date text box, enter the date you purchased the bond.
Be sure to enter the date correctly. Money needs this date to calculate the bond's value over time.
6. On the Investment drop-down menu, enter a name for the bond and click the Tab button.
After you enter the name, you see the Create New Investment dialog box.
7. Select Bond in the What Type of Investment Is It list, and click the Next button.
You see the first of several New Bond dialog boxes.
8. Select the type of bond, and click the Next button.
If you can't find the kind of bond you are dealing with in the list, select the Other Bond Type option.
9. Make sure that the name you entered is correct in the Name text box, choose a country in the Country/Region drop-down list, and click the Next button.
Now you're getting somewhere. You see the Enter a Few More Bond Details dialog box.
10. Describe the bond, and click the Next button.
To describe the bond, enter information in these text boxes:
• Rating: Moody and Standard & Poor's rate bonds according to their reliability. If you know the rating, choose it from the drop-down menu. You can generate Money reports on the basis of bond ratings.
• Coupon Rate: Enter the annual interest rate that the bond pays.
• Interest Paid: From the drop-down menu, choose the frequency with which interest income from the bond is paid.
• Maturity Date: Enter the date at which the bond falls due and is to be paid back to you.
• Call Date: Enter the earliest date that the bond can be redeemed. If the bond is redeemable at more than one date, enter the earliest date. You are only guaranteed interest payments up to the call date.
• Status: Select the Tax-Exempt check box if interest income from the bond is exempt from federal taxes. This is the case with most municipal bonds.
11. Click the Finish button.
You return to the Edit Transaction dialog box.
12. On the Transfer From drop-down menu, choose the account in which you track the value of the bond.
Money to pay for the bond is transferred from the cash reserves in your investment or retirement account.
13. In the Quantity text box, enter the face value of the bond.
The face value, also called the par value, is the value of the bond when it matures. Most bonds have a $1,000 face value. The face value is used to calculate interest payments. For example, a 5 percent bond with a face value of $1,000 pays $50 interest annually.
14. In the Price text box, enter the price of the bond.
The price of a bond is stated as a percentage of the bond's face value.
15. In the Accrued Int. text box, enter how much interest income, if any, has accumulated between the last interest payment date and the date of the sale.
Enter 0 if you have not sold this bond yet.
16. If you paid your broker a commission for purchasing this bond, enter it in the Commission text box.
17. Click OK.
Your bond is listed in the Portfolio Manager window.
Recording interest payments from bonds
Periodically, creditors pay interest on bonds you own, and when they pay up, follow these steps to record interest income from a bond:
1. Click the Investing tab and, in the Investing window, click the Portfolio Manager link.
You see the Portfolio Manager window.
2. If necessary, click the name of the account where you track the bond from which you received an interest payment.
To see the name of bonds and other investments in an account, you click the account's name, but if the investment names are already displayed, you don't have to click an account name.
3. Click the name of the bond.
4. Click the New button.
A transaction form appears.
5. On the Activity drop-down menu, choose Interest.
6. Enter the amount of the interest payment in the Total text box.
7. Click OK.
The interest payment is recorded in the miniregister.
Read on to find out how to track bond purchases and interest distributions with Money.
Recording the purchase of a bond
When you purchase a bond, follow these steps to record its purchase:
1. Click the Investing tab.
2. Click the Portfolio Manager link.
The Portfolio Manager window appears.
3. Click the Work with Investments link, and then choose Record a Buy on the drop-down menu.
The Edit Transaction dialog box appears.
4. On the Inv. Account drop-down menu, select the name of the investment or retirement account where you want to record the purchase of the bond.
5. In the Date text box, enter the date you purchased the bond.
Be sure to enter the date correctly. Money needs this date to calculate the bond's value over time.
6. On the Investment drop-down menu, enter a name for the bond and click the Tab button.
After you enter the name, you see the Create New Investment dialog box.
7. Select Bond in the What Type of Investment Is It list, and click the Next button.
You see the first of several New Bond dialog boxes.
8. Select the type of bond, and click the Next button.
If you can't find the kind of bond you are dealing with in the list, select the Other Bond Type option.
9. Make sure that the name you entered is correct in the Name text box, choose a country in the Country/Region drop-down list, and click the Next button.
Now you're getting somewhere. You see the Enter a Few More Bond Details dialog box.
10. Describe the bond, and click the Next button.
To describe the bond, enter information in these text boxes:
• Rating: Moody and Standard & Poor's rate bonds according to their reliability. If you know the rating, choose it from the drop-down menu. You can generate Money reports on the basis of bond ratings.
• Coupon Rate: Enter the annual interest rate that the bond pays.
• Interest Paid: From the drop-down menu, choose the frequency with which interest income from the bond is paid.
• Maturity Date: Enter the date at which the bond falls due and is to be paid back to you.
• Call Date: Enter the earliest date that the bond can be redeemed. If the bond is redeemable at more than one date, enter the earliest date. You are only guaranteed interest payments up to the call date.
• Status: Select the Tax-Exempt check box if interest income from the bond is exempt from federal taxes. This is the case with most municipal bonds.
11. Click the Finish button.
You return to the Edit Transaction dialog box.
12. On the Transfer From drop-down menu, choose the account in which you track the value of the bond.
Money to pay for the bond is transferred from the cash reserves in your investment or retirement account.
13. In the Quantity text box, enter the face value of the bond.
The face value, also called the par value, is the value of the bond when it matures. Most bonds have a $1,000 face value. The face value is used to calculate interest payments. For example, a 5 percent bond with a face value of $1,000 pays $50 interest annually.
14. In the Price text box, enter the price of the bond.
The price of a bond is stated as a percentage of the bond's face value.
15. In the Accrued Int. text box, enter how much interest income, if any, has accumulated between the last interest payment date and the date of the sale.
Enter 0 if you have not sold this bond yet.
16. If you paid your broker a commission for purchasing this bond, enter it in the Commission text box.
17. Click OK.
Your bond is listed in the Portfolio Manager window.
Recording interest payments from bonds
Periodically, creditors pay interest on bonds you own, and when they pay up, follow these steps to record interest income from a bond:
1. Click the Investing tab and, in the Investing window, click the Portfolio Manager link.
You see the Portfolio Manager window.
2. If necessary, click the name of the account where you track the bond from which you received an interest payment.
To see the name of bonds and other investments in an account, you click the account's name, but if the investment names are already displayed, you don't have to click an account name.
3. Click the name of the bond.
4. Click the New button.
A transaction form appears.
5. On the Activity drop-down menu, choose Interest.
6. Enter the amount of the interest payment in the Total text box.
7. Click OK.
The interest payment is recorded in the miniregister.
Resisting the Credit Temptation
Some debt is good and some is bad. Debt used for investing in your future, such as borrowing money to afford an education, buy real estate, or invest in a small business, is good debt. But accumulating bad debt (consumer debt) is like living on a diet of sugar and caffeine: a quick fix with no long-term nutritional value. Borrowing on your credit card to afford that vacation to Cabo is costly and detrimental to your long-term financial health.
Getting rid of your consumer debts may be even more difficult than giving up the sugar-laden foods you love. But in the long run, you'll be glad you did; you'll be financially healthier and emotionally happier. If you have the savings to pay off high-interest credit card and auto loans, do so. You diminish your savings, true, but you also reduce your debts. You benefit financially because the interest on your savings is far less than the interest your debt accrues. Make sure to pay off the loans with the highest interest rates first.
Having consumer loans on a credit card at, say, 12 percent and paying them off is like finding an investment with a guaranteed return of 12 percent — tax-free. You would actually need an investment that yielded even more — around 18 percent — to net 12 percent after paying taxes in order to justify not paying off your 12 percent loans. The higher your tax bracket, the higher the return you need on your investments to justify keeping high-interest consumer debt.
After you get rid of your high-cost consumer debts, practice the best way to deal with credit problems: Don't take on consumer debt.In addition to eliminating all your credit cards and getting a debit card, you can use the following tactics to limit the influence that credit cards hold over your life in the future:
Don't keep a credit card that charges you an annual fee. Many no-fee credit cards exist — and some even offer you a benefit for using them. For example, Discover Card ( 800-347-2683) rebates up to 1 percent of purchases in cash. GM Card ( 800-846-2273) gives credits worth 5 percent of charges toward the purchase of a GM-manufactured vehicle. (Saabs, Saturns, and EV1s are excluded.) No-fee cards are also offered by AFBA Industrial Bank ( 800-776-2265) and USAA Federal Savings ( 800-922-9092). Only consider these four cards if you pay your balance in full each month because you'll pay high interest rates for balances carried month-to-month. There's not much point in earning a small reward only to have it negated by greater interest charges.
Don't be tempted to charge more on a card simply because it rewards you for purchases. Spending more than you would otherwise to rack up bonuses defeats the purpose of getting the credits.
Reduce your credit limit. If you choose not to get rid of all your credit cards or secure a debit card, be sure to keep a lid on your credit card's credit limit. Just because your bank keeps raising your credit limit to reward you for being such a profitable customer doesn't mean that you have to accept the increase. Call your credit card service's 800 number and lower your credit limit to a level you're comfortable with.
Replace your credit card with a charge card. A charge card (such as the American Express Card) requires you to pay your balance in full each billing period. You have no credit line or interest charges. Of course, spending more than you can afford to pay when the bill comes due is possible. But you'll be much less likely to overspend if you know you have to pay in full monthly.
Never buy on credit anything that depreciates in value. Meals out, cars, clothing, and shoes all depreciate in value. Never buy these things on credit. Borrow money only for sound investments — education, real estate, or your own business, for example.
Think in terms of total cost. Everything sounds cheaper in terms of monthly payments — that's how salespeople lure you into buying things you don't have the money to afford. Take a calculator along if necessary to tally up the sticker price, interest charges, and upkeep. The total cost will scare you. It should.
Stop the junk mail avalanche. Look at your daily mail —half of it is probably solicitations and mail-order catalogs. Save some trees and your time sorting junk mail by removing yourself from most mailing lists. Write to the Direct Marketing Association, Mail Preference Service, P.O. Box 9008, Farmingdale, NY 11735-9008. To remove your name from the major credit reporting agency lists that are used by credit card solicitation companies, call 888-567-8688. Also, be sure to tell any credit card companies you keep cards with that you want your account marked to indicate that you do not wish to have any of your personal information shared with telemarketing firms.
Limit what you can spend. Go shopping with a small amount of cash and no plastic or checks. That way you can only spend what little cash you have with you.
Remember, the best way to reduce the costs of debt is to avoid it in the first place when you're making consumption purchases.
If you have a credit card that charges an annual fee, try calling the company and saying that you want to cancel the card because you can get a competitor's card without an annual fee. Many banks will agree to waive the fee on the spot. Some require you to call back yearly to cancel the fee — a hassle that can be avoided by getting a true no-fee card.
Getting rid of your consumer debts may be even more difficult than giving up the sugar-laden foods you love. But in the long run, you'll be glad you did; you'll be financially healthier and emotionally happier. If you have the savings to pay off high-interest credit card and auto loans, do so. You diminish your savings, true, but you also reduce your debts. You benefit financially because the interest on your savings is far less than the interest your debt accrues. Make sure to pay off the loans with the highest interest rates first.
Having consumer loans on a credit card at, say, 12 percent and paying them off is like finding an investment with a guaranteed return of 12 percent — tax-free. You would actually need an investment that yielded even more — around 18 percent — to net 12 percent after paying taxes in order to justify not paying off your 12 percent loans. The higher your tax bracket, the higher the return you need on your investments to justify keeping high-interest consumer debt.
After you get rid of your high-cost consumer debts, practice the best way to deal with credit problems: Don't take on consumer debt.In addition to eliminating all your credit cards and getting a debit card, you can use the following tactics to limit the influence that credit cards hold over your life in the future:
Don't keep a credit card that charges you an annual fee. Many no-fee credit cards exist — and some even offer you a benefit for using them. For example, Discover Card ( 800-347-2683) rebates up to 1 percent of purchases in cash. GM Card ( 800-846-2273) gives credits worth 5 percent of charges toward the purchase of a GM-manufactured vehicle. (Saabs, Saturns, and EV1s are excluded.) No-fee cards are also offered by AFBA Industrial Bank ( 800-776-2265) and USAA Federal Savings ( 800-922-9092). Only consider these four cards if you pay your balance in full each month because you'll pay high interest rates for balances carried month-to-month. There's not much point in earning a small reward only to have it negated by greater interest charges.
Don't be tempted to charge more on a card simply because it rewards you for purchases. Spending more than you would otherwise to rack up bonuses defeats the purpose of getting the credits.
Reduce your credit limit. If you choose not to get rid of all your credit cards or secure a debit card, be sure to keep a lid on your credit card's credit limit. Just because your bank keeps raising your credit limit to reward you for being such a profitable customer doesn't mean that you have to accept the increase. Call your credit card service's 800 number and lower your credit limit to a level you're comfortable with.
Replace your credit card with a charge card. A charge card (such as the American Express Card) requires you to pay your balance in full each billing period. You have no credit line or interest charges. Of course, spending more than you can afford to pay when the bill comes due is possible. But you'll be much less likely to overspend if you know you have to pay in full monthly.
Never buy on credit anything that depreciates in value. Meals out, cars, clothing, and shoes all depreciate in value. Never buy these things on credit. Borrow money only for sound investments — education, real estate, or your own business, for example.
Think in terms of total cost. Everything sounds cheaper in terms of monthly payments — that's how salespeople lure you into buying things you don't have the money to afford. Take a calculator along if necessary to tally up the sticker price, interest charges, and upkeep. The total cost will scare you. It should.
Stop the junk mail avalanche. Look at your daily mail —half of it is probably solicitations and mail-order catalogs. Save some trees and your time sorting junk mail by removing yourself from most mailing lists. Write to the Direct Marketing Association, Mail Preference Service, P.O. Box 9008, Farmingdale, NY 11735-9008. To remove your name from the major credit reporting agency lists that are used by credit card solicitation companies, call 888-567-8688. Also, be sure to tell any credit card companies you keep cards with that you want your account marked to indicate that you do not wish to have any of your personal information shared with telemarketing firms.
Limit what you can spend. Go shopping with a small amount of cash and no plastic or checks. That way you can only spend what little cash you have with you.
Remember, the best way to reduce the costs of debt is to avoid it in the first place when you're making consumption purchases.
If you have a credit card that charges an annual fee, try calling the company and saying that you want to cancel the card because you can get a competitor's card without an annual fee. Many banks will agree to waive the fee on the spot. Some require you to call back yearly to cancel the fee — a hassle that can be avoided by getting a true no-fee card.
Identifying Common Financial Problems
How financially healthy are you? You may already know the bad news. Or perhaps things aren't quite as bad as they seem.
When was the last time you sat down surrounded by all of your personal and financial documents and took stock of your overall financial situation, including reviewing your spending, savings, future goals, and insurance? If you're like most people, you've either never done this exercise or did so a long time ago.
Financial problems, like many medical problems, are best detected early (clean living doesn't hurt, either). Here are some common personal financial problems:
Not planning. Human beings were born to procrastinate. That's why there are deadlines — and deadline extensions. With your finances, unfortunately, you have no deadlines, and you may think you have unlimited extensions! You can allow your credit card debt to accumulate or leave your savings sitting in lousy investments for years. You can pay higher taxes, leave gaps in your retirement and insurance coverage, and overpay for financial products. Of course, planning your finances isn't as much fun as planning a vacation, but doing the former will help you take more of the latter.
Overspending. The average American saves less than 5 percent of his after-tax income (in contrast to those in other industrialized countries, where the savings rate is two to three times that in America). Simple arithmetic helps you determine that savings is the difference between what you earn and what you spend (assuming you're not spending more than you're earning!). To increase your savings, you either have to work more (yuck!), know a wealthy family who wants to leave its fortune to you, or spend less. For most people, the thrifty approach is the key to building savings and wealth.
Buying with consumer credit. Even with the benefit of today's lower interest rates, carrying a balance month-to-month on your credit card or buying a car on credit means that even more of your future earnings are earmarked for debt repayment. Buying on credit encourages you to spend more than you can really afford.
Delaying saving for retirement. Most people say they want to retire by their mid-60s or sooner. But in order to accomplish this financially, most people need to save a reasonable chunk (around 10 percent) of their incomes starting sooner rather than later. The longer you wait to start saving for retirement, the harder it will be to reach your goal. And you'll pay much more in taxes to boot if you don't take advantage of the tax benefits achieved by investing through particular retirement accounts.
Falling prey to financial sales pitches. Great deals that can't wait for a little reflection or a second opinion are often disasters waiting to happen. A sucker may be born every minute, but a slick salesperson is born every second! Steer clear of those who pressure you to make decisions, promise high investment returns, and lack the proper training and experience to help you.
Not doing your homework. To get the best deal, you need to shop around, read reviews, and get advice from disinterested, objective third parties. You need to check references and track records so you don't hire incompetent, self-serving, or fraudulent financial advisers. But with all the different financial products available, making informed financial decisions has become an overwhelming task.
Making decisions based on emotion. You are most vulnerable to making the wrong moves financially after a major life change (a job loss or divorce, for example) or when you feel under pressure. Maybe your investments have plunged in value. Or perhaps a recent divorce has you fearing that you won't be able to afford to retire when you had planned, so you pour thousands of dollars into some newfangled financial product. Take your time and keep your emotions out of the picture.
Not separating the wheat from the chaff. In any field in which you're not an expert, you run the danger of following the advice of someone who you think is an expert but really isn't. If you look in the mirror, you'll see the person who is best able to manage your personal finances. Educate and trust yourself!
Exposing yourself to catastrophic risk. You're vulnerable if you or your family don't have insurance to pay for financially devastating losses. People without a savings reserve and support network can end up homeless. Many people lack sufficient insurance coverage to replace their income. Don't wait for a tragedy to strike to learn whether you have the right insurance coverage.
Focusing too much on money. Too much emphasis on making and saving money can warp your perspective on what's important in life. Money is not the first or even second priority in happy people's lives. Your health, relationships with family and friends, career satisfaction, and fulfilling interests should be more important.
Most problems can be fixed over time with changes in your behavior.
When was the last time you sat down surrounded by all of your personal and financial documents and took stock of your overall financial situation, including reviewing your spending, savings, future goals, and insurance? If you're like most people, you've either never done this exercise or did so a long time ago.
Financial problems, like many medical problems, are best detected early (clean living doesn't hurt, either). Here are some common personal financial problems:
Not planning. Human beings were born to procrastinate. That's why there are deadlines — and deadline extensions. With your finances, unfortunately, you have no deadlines, and you may think you have unlimited extensions! You can allow your credit card debt to accumulate or leave your savings sitting in lousy investments for years. You can pay higher taxes, leave gaps in your retirement and insurance coverage, and overpay for financial products. Of course, planning your finances isn't as much fun as planning a vacation, but doing the former will help you take more of the latter.
Overspending. The average American saves less than 5 percent of his after-tax income (in contrast to those in other industrialized countries, where the savings rate is two to three times that in America). Simple arithmetic helps you determine that savings is the difference between what you earn and what you spend (assuming you're not spending more than you're earning!). To increase your savings, you either have to work more (yuck!), know a wealthy family who wants to leave its fortune to you, or spend less. For most people, the thrifty approach is the key to building savings and wealth.
Buying with consumer credit. Even with the benefit of today's lower interest rates, carrying a balance month-to-month on your credit card or buying a car on credit means that even more of your future earnings are earmarked for debt repayment. Buying on credit encourages you to spend more than you can really afford.
Delaying saving for retirement. Most people say they want to retire by their mid-60s or sooner. But in order to accomplish this financially, most people need to save a reasonable chunk (around 10 percent) of their incomes starting sooner rather than later. The longer you wait to start saving for retirement, the harder it will be to reach your goal. And you'll pay much more in taxes to boot if you don't take advantage of the tax benefits achieved by investing through particular retirement accounts.
Falling prey to financial sales pitches. Great deals that can't wait for a little reflection or a second opinion are often disasters waiting to happen. A sucker may be born every minute, but a slick salesperson is born every second! Steer clear of those who pressure you to make decisions, promise high investment returns, and lack the proper training and experience to help you.
Not doing your homework. To get the best deal, you need to shop around, read reviews, and get advice from disinterested, objective third parties. You need to check references and track records so you don't hire incompetent, self-serving, or fraudulent financial advisers. But with all the different financial products available, making informed financial decisions has become an overwhelming task.
Making decisions based on emotion. You are most vulnerable to making the wrong moves financially after a major life change (a job loss or divorce, for example) or when you feel under pressure. Maybe your investments have plunged in value. Or perhaps a recent divorce has you fearing that you won't be able to afford to retire when you had planned, so you pour thousands of dollars into some newfangled financial product. Take your time and keep your emotions out of the picture.
Not separating the wheat from the chaff. In any field in which you're not an expert, you run the danger of following the advice of someone who you think is an expert but really isn't. If you look in the mirror, you'll see the person who is best able to manage your personal finances. Educate and trust yourself!
Exposing yourself to catastrophic risk. You're vulnerable if you or your family don't have insurance to pay for financially devastating losses. People without a savings reserve and support network can end up homeless. Many people lack sufficient insurance coverage to replace their income. Don't wait for a tragedy to strike to learn whether you have the right insurance coverage.
Focusing too much on money. Too much emphasis on making and saving money can warp your perspective on what's important in life. Money is not the first or even second priority in happy people's lives. Your health, relationships with family and friends, career satisfaction, and fulfilling interests should be more important.
Most problems can be fixed over time with changes in your behavior.
Getting Loans
Sometimes, it may seem as though lenders are trying to give away money by making credit so easily available. But this is a dangerous illusion. When it comes to consumer debt (credit cards, auto loans, and the like), lenders aren't giving away anything except the opportunity for you to get in over your head, rack up high interest charges, and delay your progress toward your financial and personal goals.
Credit is most dangerous when you make consumption purchases that you couldn't afford in the first place.
Nevertheless, there are times when you need to borrow: to buy a house, to pay for college, to start your own business, to pay unexpected medical expenses, and sometimes to give in to the temptation to purchase something you've always wanted. The way you get a loan is by establishing creditworthiness. You are deemed worthy of credit if you have sufficient assets to repay the loan and if you have a good history of loan-repayment, based on your credit report. If your record of repayment is poor, you'll either be denied the loan, have to pay higher-than-normal interest charges (interest rates vary depending on the nature of the loan, the loan agency, and the health of the nation's economy), or, depending on the purpose of the loan, you may qualify for government assistance.
All loans are either secured or unsecured.
The most common items purchased by a secured loan are houses, cars, household furnishings, and jewelry. Unsecured loans include loans to pay credit card debt, college expenses, vacation costs, and medical bills. Because unsecured loans are riskier for lenders, most of these loans have higher interest rates than secured loans do, usually representing the biggest drain on your finances.
Before you ask for a loan, be sure that your loan payments won't strain your budget. Try to make extra payments on the loan or pay it off early if there are no penalties to do so. If practical, consider a home equity loan as you can usually get a lower interest rate and the interest is tax deductible. Just be certain you can make the payments, as your home is at risk if you can't.
You can get loans from your bank, savings and loan, credit union, and a host of vendors and other agencies with money to lend.
Credit is most dangerous when you make consumption purchases that you couldn't afford in the first place.
Nevertheless, there are times when you need to borrow: to buy a house, to pay for college, to start your own business, to pay unexpected medical expenses, and sometimes to give in to the temptation to purchase something you've always wanted. The way you get a loan is by establishing creditworthiness. You are deemed worthy of credit if you have sufficient assets to repay the loan and if you have a good history of loan-repayment, based on your credit report. If your record of repayment is poor, you'll either be denied the loan, have to pay higher-than-normal interest charges (interest rates vary depending on the nature of the loan, the loan agency, and the health of the nation's economy), or, depending on the purpose of the loan, you may qualify for government assistance.
All loans are either secured or unsecured.
The most common items purchased by a secured loan are houses, cars, household furnishings, and jewelry. Unsecured loans include loans to pay credit card debt, college expenses, vacation costs, and medical bills. Because unsecured loans are riskier for lenders, most of these loans have higher interest rates than secured loans do, usually representing the biggest drain on your finances.
Before you ask for a loan, be sure that your loan payments won't strain your budget. Try to make extra payments on the loan or pay it off early if there are no penalties to do so. If practical, consider a home equity loan as you can usually get a lower interest rate and the interest is tax deductible. Just be certain you can make the payments, as your home is at risk if you can't.
You can get loans from your bank, savings and loan, credit union, and a host of vendors and other agencies with money to lend.
Considering Nanny Taxes When Choosing Childcare
You've no doubt heard all the buzz about the various "nanny taxes" that employers are required to remit to the government if they happen to employ a nanny or other in-home employee. Although you may be tempted to try to avoid paying these nanny taxes in the hope of trimming your payroll costs — tax experts estimate that playing by the nanny tax rules boosts payroll expenditures by approximately 11 percent — you may want to think twice before making this gamble.
You see, trying to dodge the nanny tax can be very risky business indeed. If you get caught, you may find yourself on the hook for your share of the back taxes, the nanny's share, plus the usual penalties and interest. You even leave yourself open to criminal prosecution if you knowingly lied on your tax return about the fact that you owed nanny taxes. (Remember that when you sign on the bottom line of your tax return, you're swearing that your return is true, correct, and complete. If you lie, you're committing perjury, which is a major federal offense.)
Although some folks argue that the risks of getting caught are virtually nil, they're being overly optimistic. If your former employee were to apply for unemployment benefits, worker's compensation benefits, or Social Security benefits even many years after the fact, the IRS could come after you to try to collect any unpaid nanny taxes. (The nanny tax has no three-year statute of limitations on errors or omissions. You're on the hook, period.)
So simply accept the fact that nanny taxes are part of the cost of hiring a nanny and fork over the necessary cash to the IRS. If nothing else, you'll sleep better at night knowing that you're playing by Uncle Sam's rules.
Here's the lowdown on the various types of taxes you should know about to stay on Uncle Sam's good side, namely
Federal income tax
Social Security and Medicare
Federal Unemployment Tax (FUTA)
State taxes
Obtaining an Employer Identification Number (EIN)
Collecting employment taxes is one of the least fun aspects of being an employer. These taxes are a pain to calculate, a pain to collect, and a pain to remit. Unfortunately, Uncle Sam doesn't give you a lot of choice in the matter. If you meet certain criteria, you're required to play tax collector, whether you like it or not.
Of course, before you can report employment taxes or start issuing tax statements to employees, you need to apply for an Employer Identification Number (EIN), which is a nine-digit number that the IRS uses to identify the tax accounts of employers. You can apply for an EIN by mail by completing Form SS-4, or you can apply by phone. (Call your local IRS office or visit the IRS Web site.)
If you haven't received your EIN by the time your first tax payment is due, you'll have to make your deposit directly to the IRS. (You won't be able to make your payment via a financial institution until you receive your EIN.)
Whatever you do, don't hold off on making your payment until you receive your EIN. The penalties for making late payments are fairly hefty, ranging from 2 percent for deposits that are made one to five days late to 15 percent for accounts that are still unpaid after the IRS has sent you an official notice that your account is past due. (Ouch!)
Federal income tax
Although you aren't required to withhold income taxes from your nanny's paychecks, she may want you to anyway to avoid getting hit with a hefty tax bill in the spring. If she asks you to withhold income tax and to remit it to the government on her behalf, you'll need her to complete and sign a Form W-4: Employee Withholding Allowance Certificate. This form, which summarizes her filing status and how many exemptions she qualifies for, will assist you in calculating how much tax you should withhold from each paycheck.
By the way, you may find yourself having to advance tax money to the nanny if she happens to qualify for the Earned Income Credit (a federal tax credit for low-income workers). If she provides you with a properly completed Form W-5: Earned Income Credit Advance Payment Certificate, you'll be required to advance her some of this credit on each paycheck.
For more on tax issues, see Publication 926: Household Employer's Tax Guide, available from any IRS office or from the IRS Web site.
Social Security and Medicare
Social Security taxes fund old-age, survivor, and disability benefits for workers and their families, and the Medicare tax pays for hospital insurance. After the wages you pay your nanny reach a certain threshold determined by the IRS (in 2003, that threshold was $1,400 per year), you're required to pay both these taxes on your nanny's wages.
Technically speaking, you and the nanny are responsible for each paying half of the Social Security and Medicare taxes, but many employers choose to cover both the employer and employee portions of these taxes. Because the two taxes amount to 15.3 percent of the total wages, and her share is half this amount, picking up the tab for her half would cost you 7.65 percent of her wages.
Whether you decide to pay the total cost or just your share, you're the one who's responsible for ensuring that these taxes get remitted to the IRS.
Federal unemployment tax
The Federal Unemployment Tax Act (FUTA), in conjunction with state unemployment systems, provides compensation to workers who've lost their jobs.
The FUTA tax typically amounts to 6.2 percent of your employee's FUTA wages. However, you are able to take a credit of up to 5.4 percent against the FUTA tax, which brings the net tax down to just 0.8 percent, provided that you paid all your previous year's state unemployment taxes on time.
Depending on where you live, you may be required to pay both the federal unemployment tax (the FUTA tax) and the state unemployment tax. Or you may only be required to pay one or the other. To find out about the rules in your state, contact your state unemployment tax agency. (Check the government pages of your local phone book.)
State taxes
Even if you don't actually have to fork over any cash for any federal taxes, you may still be required to pay taxes for unemployment and workers' compensation insurance. In most states, you become liable for state employment taxes as soon as your total payroll (for all employees, not just a single employee) exceeds $1,000 per calendar quarter. Of course, this threshold is much lower in some states. It's just half this amount ($500) in New York and the District of Columbia.
You see, trying to dodge the nanny tax can be very risky business indeed. If you get caught, you may find yourself on the hook for your share of the back taxes, the nanny's share, plus the usual penalties and interest. You even leave yourself open to criminal prosecution if you knowingly lied on your tax return about the fact that you owed nanny taxes. (Remember that when you sign on the bottom line of your tax return, you're swearing that your return is true, correct, and complete. If you lie, you're committing perjury, which is a major federal offense.)
Although some folks argue that the risks of getting caught are virtually nil, they're being overly optimistic. If your former employee were to apply for unemployment benefits, worker's compensation benefits, or Social Security benefits even many years after the fact, the IRS could come after you to try to collect any unpaid nanny taxes. (The nanny tax has no three-year statute of limitations on errors or omissions. You're on the hook, period.)
So simply accept the fact that nanny taxes are part of the cost of hiring a nanny and fork over the necessary cash to the IRS. If nothing else, you'll sleep better at night knowing that you're playing by Uncle Sam's rules.
Here's the lowdown on the various types of taxes you should know about to stay on Uncle Sam's good side, namely
Federal income tax
Social Security and Medicare
Federal Unemployment Tax (FUTA)
State taxes
Obtaining an Employer Identification Number (EIN)
Collecting employment taxes is one of the least fun aspects of being an employer. These taxes are a pain to calculate, a pain to collect, and a pain to remit. Unfortunately, Uncle Sam doesn't give you a lot of choice in the matter. If you meet certain criteria, you're required to play tax collector, whether you like it or not.
Of course, before you can report employment taxes or start issuing tax statements to employees, you need to apply for an Employer Identification Number (EIN), which is a nine-digit number that the IRS uses to identify the tax accounts of employers. You can apply for an EIN by mail by completing Form SS-4, or you can apply by phone. (Call your local IRS office or visit the IRS Web site.)
If you haven't received your EIN by the time your first tax payment is due, you'll have to make your deposit directly to the IRS. (You won't be able to make your payment via a financial institution until you receive your EIN.)
Whatever you do, don't hold off on making your payment until you receive your EIN. The penalties for making late payments are fairly hefty, ranging from 2 percent for deposits that are made one to five days late to 15 percent for accounts that are still unpaid after the IRS has sent you an official notice that your account is past due. (Ouch!)
Federal income tax
Although you aren't required to withhold income taxes from your nanny's paychecks, she may want you to anyway to avoid getting hit with a hefty tax bill in the spring. If she asks you to withhold income tax and to remit it to the government on her behalf, you'll need her to complete and sign a Form W-4: Employee Withholding Allowance Certificate. This form, which summarizes her filing status and how many exemptions she qualifies for, will assist you in calculating how much tax you should withhold from each paycheck.
By the way, you may find yourself having to advance tax money to the nanny if she happens to qualify for the Earned Income Credit (a federal tax credit for low-income workers). If she provides you with a properly completed Form W-5: Earned Income Credit Advance Payment Certificate, you'll be required to advance her some of this credit on each paycheck.
For more on tax issues, see Publication 926: Household Employer's Tax Guide, available from any IRS office or from the IRS Web site.
Social Security and Medicare
Social Security taxes fund old-age, survivor, and disability benefits for workers and their families, and the Medicare tax pays for hospital insurance. After the wages you pay your nanny reach a certain threshold determined by the IRS (in 2003, that threshold was $1,400 per year), you're required to pay both these taxes on your nanny's wages.
Technically speaking, you and the nanny are responsible for each paying half of the Social Security and Medicare taxes, but many employers choose to cover both the employer and employee portions of these taxes. Because the two taxes amount to 15.3 percent of the total wages, and her share is half this amount, picking up the tab for her half would cost you 7.65 percent of her wages.
Whether you decide to pay the total cost or just your share, you're the one who's responsible for ensuring that these taxes get remitted to the IRS.
Federal unemployment tax
The Federal Unemployment Tax Act (FUTA), in conjunction with state unemployment systems, provides compensation to workers who've lost their jobs.
The FUTA tax typically amounts to 6.2 percent of your employee's FUTA wages. However, you are able to take a credit of up to 5.4 percent against the FUTA tax, which brings the net tax down to just 0.8 percent, provided that you paid all your previous year's state unemployment taxes on time.
Depending on where you live, you may be required to pay both the federal unemployment tax (the FUTA tax) and the state unemployment tax. Or you may only be required to pay one or the other. To find out about the rules in your state, contact your state unemployment tax agency. (Check the government pages of your local phone book.)
State taxes
Even if you don't actually have to fork over any cash for any federal taxes, you may still be required to pay taxes for unemployment and workers' compensation insurance. In most states, you become liable for state employment taxes as soon as your total payroll (for all employees, not just a single employee) exceeds $1,000 per calendar quarter. Of course, this threshold is much lower in some states. It's just half this amount ($500) in New York and the District of Columbia.
Meeting the "Big Three" Federal Estate-Related Taxes
The Bermuda Triangle, as you recall, is that stretch of ocean where ships and airplanes have disappeared without a trace. The federal tax system has its own Bermuda Triangle — a trio of taxes that work together to make as much of your estate as possible disappear without a trace: the estate (death) tax, the gift tax, and the generation skipping transfer tax (or GSTT) .
Navigating through federal estate taxes
The folks who wrote the laws and rules for the federal estate, gift, and GSTT taxes created some confusing relationships among the three taxes. You absolutely, positively want to use the experts on your estate-planning team — particularly your accountant and your attorney — to help you make sense of the odd relationships among these taxes.
The gift tax
The federal gift tax is imposed on taxable gifts that you give to others. The premise behind the gift tax is fairly straightforward. If you try to avoid estate taxes by giving away a significant portion of your estate while you're still alive, the government applies a tax on those gifts — sort of a "pay me now because you're not going to be paying me later!" approach.
The sort-of-good news is that you have a variety of exemptions and allowances to work with in your gift giving to help you minimize the actual tax bite or even escape the tax bite completely in some cases. Also, even if you make taxable gifts, you may not ever have to actually pay gift taxes (that is, to actually write a check for the amount you owe) because you can credit the amount of gift tax you owe against any down-the-road estate tax after you die.
The generation skipping transfer tax, or GSTT
The GSTT closes a loophole that the upper class has used to reduce estate taxes. For many years, wealthy people directly transferred some of their property to members of lower generations — to grandchildren rather than children.
The idea was that if a wealthy grandfather left lots of money to his own children who were wealthy in their own right, then they'd never need to spend that money — and most of what the grandfather gave as gifts or left in his will was taxed. Then, when the grandfather's children died, that same money that they didn't need to spend or otherwise get rid of once again was taxed when it was passed to their own children. So the grandfather thought ahead and just gave or left the money directly to the grandchildren or set up certain types of trusts, and essentially the money was taxed (for estate purposes, not for income purposes) only once instead of twice because the grandfather had skipped over an entire generation within his family.
Think of the GSTT as "closing the generation skipping loophole" (at least, GSTT proponents position and explain the tax that way) by adding an additional tax — and at pretty hefty rates — to property transfers that can be classified as generation skipping to make up for the amount of tax that you're trying not to pay.
The good news, though, is that you have a sizable exemption amount to work with, and you can work with your attorney and accountant to minimize the GSTT bite.
The estate (death) tax
The federal estate tax is scheduled to go away in 2010, but you — and everyone else — still need to worry about the federal estate tax, no matter how big (or small) your estate is. The death of the estate tax may only be for a single year. Unless Congress explicitly acts to extend the federal estate tax repeal (meaning that 2010 has no estate tax), the estate tax comes back in 2011.
Deciphering state inheritance and estate taxes
Depending on where you live, your state inheritance and estate tax situation will be one of these four scenarios:
No estate-related taxes at all — lucky you!
A state estate tax, which operates much the same way as the federal estate tax does. A tax is imposed on your estate's value and is paid out of your estate (typically by your personal representative).
A state inheritance tax, which actually taxes your beneficiaries on what they receive, rather than the estate itself. Don't forget that the primary responsibility for filing the inheritance tax return and paying the tax usually falls on the personal representative.
A pick-up or soak-up tax, which is a sort of tax: Your estate doesn't actually owe any additional money to pay that tax, even though a state estate tax return likely needs to be filed. The state gets a cut of what would otherwise be paid to the IRS (but your personal representative still probably has to file a lot of state tax paperwork anyway).
Keep in mind several points about state death taxes. First, some states are repealing or phasing out their inheritance or estate taxes, but don't be surprised to see other states that currently don't have estate-related taxes instituting either an inheritance or estate tax. Whereas most state governments had budget surpluses throughout the 1990s, the early 2000s have been quite a different story with deficits coming back as a result of economic slowdown. As a result, states are looking to all kinds of new or increased sources of revenue to help cover shortfalls.
Navigating through federal estate taxes
The folks who wrote the laws and rules for the federal estate, gift, and GSTT taxes created some confusing relationships among the three taxes. You absolutely, positively want to use the experts on your estate-planning team — particularly your accountant and your attorney — to help you make sense of the odd relationships among these taxes.
The gift tax
The federal gift tax is imposed on taxable gifts that you give to others. The premise behind the gift tax is fairly straightforward. If you try to avoid estate taxes by giving away a significant portion of your estate while you're still alive, the government applies a tax on those gifts — sort of a "pay me now because you're not going to be paying me later!" approach.
The sort-of-good news is that you have a variety of exemptions and allowances to work with in your gift giving to help you minimize the actual tax bite or even escape the tax bite completely in some cases. Also, even if you make taxable gifts, you may not ever have to actually pay gift taxes (that is, to actually write a check for the amount you owe) because you can credit the amount of gift tax you owe against any down-the-road estate tax after you die.
The generation skipping transfer tax, or GSTT
The GSTT closes a loophole that the upper class has used to reduce estate taxes. For many years, wealthy people directly transferred some of their property to members of lower generations — to grandchildren rather than children.
The idea was that if a wealthy grandfather left lots of money to his own children who were wealthy in their own right, then they'd never need to spend that money — and most of what the grandfather gave as gifts or left in his will was taxed. Then, when the grandfather's children died, that same money that they didn't need to spend or otherwise get rid of once again was taxed when it was passed to their own children. So the grandfather thought ahead and just gave or left the money directly to the grandchildren or set up certain types of trusts, and essentially the money was taxed (for estate purposes, not for income purposes) only once instead of twice because the grandfather had skipped over an entire generation within his family.
Think of the GSTT as "closing the generation skipping loophole" (at least, GSTT proponents position and explain the tax that way) by adding an additional tax — and at pretty hefty rates — to property transfers that can be classified as generation skipping to make up for the amount of tax that you're trying not to pay.
The good news, though, is that you have a sizable exemption amount to work with, and you can work with your attorney and accountant to minimize the GSTT bite.
The estate (death) tax
The federal estate tax is scheduled to go away in 2010, but you — and everyone else — still need to worry about the federal estate tax, no matter how big (or small) your estate is. The death of the estate tax may only be for a single year. Unless Congress explicitly acts to extend the federal estate tax repeal (meaning that 2010 has no estate tax), the estate tax comes back in 2011.
Deciphering state inheritance and estate taxes
Depending on where you live, your state inheritance and estate tax situation will be one of these four scenarios:
No estate-related taxes at all — lucky you!
A state estate tax, which operates much the same way as the federal estate tax does. A tax is imposed on your estate's value and is paid out of your estate (typically by your personal representative).
A state inheritance tax, which actually taxes your beneficiaries on what they receive, rather than the estate itself. Don't forget that the primary responsibility for filing the inheritance tax return and paying the tax usually falls on the personal representative.
A pick-up or soak-up tax, which is a sort of tax: Your estate doesn't actually owe any additional money to pay that tax, even though a state estate tax return likely needs to be filed. The state gets a cut of what would otherwise be paid to the IRS (but your personal representative still probably has to file a lot of state tax paperwork anyway).
Keep in mind several points about state death taxes. First, some states are repealing or phasing out their inheritance or estate taxes, but don't be surprised to see other states that currently don't have estate-related taxes instituting either an inheritance or estate tax. Whereas most state governments had budget surpluses throughout the 1990s, the early 2000s have been quite a different story with deficits coming back as a result of economic slowdown. As a result, states are looking to all kinds of new or increased sources of revenue to help cover shortfalls.
Preparing for a Tax Audit
Preparing for an audit is sort of like preparing for a test in school: The IRS informs you of which sections of your tax return the agency wants to examine so that you know what to "study." The first decision you face when you get an audit notice is whether to handle it yourself or to turn to a tax adviser to represent you. Hiring representation costs money but saves you time, stress, and money.
Who can represent you?
The IRS permits three types of individuals to fully represent taxpayers before the IRS: enrolled agents, certified public accountants, and attorneys. All three are bound by IRS rules of practice. (Tax preparers can represent you at an audit but not in any appeals beyond that.)
If you normally prepare your own return and are comfortable with your understanding of the areas being audited, represent yourself. If the IRS is merely asking you to substantiate deductions, you'll probably do all right on your own. However, if you're likely to turn into a babbling, intimidated fool and are unsure of how to present your situation, hire a tax adviser to represent you.
Even if you choose to represent yourself and find yourself over your head in an audit, you've got a backup. At any time during the examination — such as when you feel a dizzy sensation — the Taxpayer Bill of Rights allows you to request that the audit be suspended until you have time to consult with either an enrolled agent, a certified public accountant, or an attorney. When you make this request, the IRS agent must stop asking questions or requesting documents until you are properly represented.
Documenting your claims
If you do decide to handle the audit yourself, don't wait until the night before to start gathering receipts and other documentation. You may discover, for example, that you can't find certain documents.
You need to document and be ready to speak with the auditor about only those areas the audit notice said were being investigated. Organize the various documents and receipts in folders. You want to make it as easy as possible for the auditor to review your materials. Don't show up, dump shopping bags full of receipts and paperwork on the auditor's desk, and say, "Here it is — you figure it out."
Don't bring documentation for parts of your return that ren't being auditied, either. You'd be creating more work for yourself; besides — you're required to discuss only those areas mentioned in the audit letter.
Whatever you do, don't ignore your audit request letter. The Internal Revenue Service is the ultimate bill-collection agency. And if you end up owing more money (the unhappy result of most audits), the sooner you pay, the less interest and penalties you'll owe.
Winning your audit
Two people with identical situations can walk into an audit and come out with very different results. The loser can end up owing much more in taxes and have the audit expanded to include other parts of the return. The winner can end up owing less tax money. Here's how to be a winner.
Treat the auditor as a human being. Believe it or not, most auditors are decent people just trying to do their jobs. They are well aware that taxpayers don't like seeing them. But you don't have to bow before them, either — just relax and be yourself. Behave as you would around a boss you like — with respect and congeniality.
Stick to the knitting. You're there to discuss only the sections of your tax return in question. The more you talk about other areas or things that you're doing, the more likely the auditor will probe into other items.
Don't argue when you disagree. State your case. If the auditor wants to disallow a deduction or otherwise increase the tax you owe and you don't agree, state only once why you don't agree. If the auditor won't budge, don't get into a knockdown, drag-out confrontation. The auditor may not want to lose face and is inclined to find additional tax money, which is the auditor's job. Remember that, when necessary, you can plead your case with several layers of people above your auditor. If this method fails and you still feel wronged, you can take your case to Tax Court.
Don't be intimidated. Most auditors are not tax geniuses. The work is stressful — being in a job where people dislike seeing you is not easy. Turnover is quite high. Thus, many auditors are fairly young, just-out-of-school types who majored in something like English, history, or sociology. They may know less about tax and financial matters than you do. The basic IRS tax boot camp that auditors go through doesn’t come close to covering all the technical details and nuances in the tax code. So you may not be at such a disadvantage in your tax knowledge after all, especially if you work with a tax advisor (most tax advisors know more about the tax system than the average IRS auditor).
Who can represent you?
The IRS permits three types of individuals to fully represent taxpayers before the IRS: enrolled agents, certified public accountants, and attorneys. All three are bound by IRS rules of practice. (Tax preparers can represent you at an audit but not in any appeals beyond that.)
If you normally prepare your own return and are comfortable with your understanding of the areas being audited, represent yourself. If the IRS is merely asking you to substantiate deductions, you'll probably do all right on your own. However, if you're likely to turn into a babbling, intimidated fool and are unsure of how to present your situation, hire a tax adviser to represent you.
Even if you choose to represent yourself and find yourself over your head in an audit, you've got a backup. At any time during the examination — such as when you feel a dizzy sensation — the Taxpayer Bill of Rights allows you to request that the audit be suspended until you have time to consult with either an enrolled agent, a certified public accountant, or an attorney. When you make this request, the IRS agent must stop asking questions or requesting documents until you are properly represented.
Documenting your claims
If you do decide to handle the audit yourself, don't wait until the night before to start gathering receipts and other documentation. You may discover, for example, that you can't find certain documents.
You need to document and be ready to speak with the auditor about only those areas the audit notice said were being investigated. Organize the various documents and receipts in folders. You want to make it as easy as possible for the auditor to review your materials. Don't show up, dump shopping bags full of receipts and paperwork on the auditor's desk, and say, "Here it is — you figure it out."
Don't bring documentation for parts of your return that ren't being auditied, either. You'd be creating more work for yourself; besides — you're required to discuss only those areas mentioned in the audit letter.
Whatever you do, don't ignore your audit request letter. The Internal Revenue Service is the ultimate bill-collection agency. And if you end up owing more money (the unhappy result of most audits), the sooner you pay, the less interest and penalties you'll owe.
Winning your audit
Two people with identical situations can walk into an audit and come out with very different results. The loser can end up owing much more in taxes and have the audit expanded to include other parts of the return. The winner can end up owing less tax money. Here's how to be a winner.
Treat the auditor as a human being. Believe it or not, most auditors are decent people just trying to do their jobs. They are well aware that taxpayers don't like seeing them. But you don't have to bow before them, either — just relax and be yourself. Behave as you would around a boss you like — with respect and congeniality.
Stick to the knitting. You're there to discuss only the sections of your tax return in question. The more you talk about other areas or things that you're doing, the more likely the auditor will probe into other items.
Don't argue when you disagree. State your case. If the auditor wants to disallow a deduction or otherwise increase the tax you owe and you don't agree, state only once why you don't agree. If the auditor won't budge, don't get into a knockdown, drag-out confrontation. The auditor may not want to lose face and is inclined to find additional tax money, which is the auditor's job. Remember that, when necessary, you can plead your case with several layers of people above your auditor. If this method fails and you still feel wronged, you can take your case to Tax Court.
Don't be intimidated. Most auditors are not tax geniuses. The work is stressful — being in a job where people dislike seeing you is not easy. Turnover is quite high. Thus, many auditors are fairly young, just-out-of-school types who majored in something like English, history, or sociology. They may know less about tax and financial matters than you do. The basic IRS tax boot camp that auditors go through doesn’t come close to covering all the technical details and nuances in the tax code. So you may not be at such a disadvantage in your tax knowledge after all, especially if you work with a tax advisor (most tax advisors know more about the tax system than the average IRS auditor).
5.13.2008
Assessing Risks and Returns from Short Selling and Leverage
Leverage introduces risk to your day trading, and that can give you greatly increased returns. Most day traders use leverage, at least part of the time, in order to make their trading activities pay off in cold, hard cash. The challenge is to use leverage responsibly. The two issues most related to leverage are losing your money and losing your nerve. Understanding those risks can help you determine how much leverage you should take, and how often you can take it.
Losing your money
Losing money is obvious. Leverage magnifies your returns, but it also magnifies your risks. Any borrowings have to be repaid regardless. If you buy or sell a futures or options contract, you are legally obligated to perform, even if you have lost money. That can be really hard. Day trading is risky in large part because of the amount of leverage used. If you don't feel comfortable with that, you may want to use little or no leverage, especially when you are new to day trading or when you are starting to work a new trading strategy.
Losing your nerve
The basic risk and return of your underlying strategy isn't affected by leverage. If you expect that your system will work about 60 percent of the time, then that should hold no matter how much money is at stake or where that money came from. However, it's likely that it does make a difference to you on some subconscious level if you have borrowed the money.
Trading is very much a game of nerves. If you hesitate to make a trade, cut a loss, or otherwise follow your strategy, you're going to run into trouble.
Say you're trading futures and decide to accept three downticks before selling, and that you will look for five upticks before selling. This means you are willing to accept some loss, cut it if it gets out of hand, and then be disciplined about taking gains when you get them. This strategy keeps a lid on your losses while forcing some discipline on your gains.
Now, suppose you are dealing with lots and lots of leverage. Suddenly, those downticks become too real to you — it's money you don't have. Next thing you know, you only accept two downticks before closing out. But this keeps you from getting winners. Then you decide to ride with your winners, and suddenly you aren't taking profits fast enough, and your positions move against you. Your fear of loss is making you sloppy. That's why many traders find it better to borrow less money and stick to their system rather than borrow the maximum allowed and let that knowledge cloud their judgment.
Lenders can lose their nerve, too. Your brokerage firm might close your account because of losses, even though waiting just a little longer might turn a losing position into a profit.
Losing your money
Losing money is obvious. Leverage magnifies your returns, but it also magnifies your risks. Any borrowings have to be repaid regardless. If you buy or sell a futures or options contract, you are legally obligated to perform, even if you have lost money. That can be really hard. Day trading is risky in large part because of the amount of leverage used. If you don't feel comfortable with that, you may want to use little or no leverage, especially when you are new to day trading or when you are starting to work a new trading strategy.
Losing your nerve
The basic risk and return of your underlying strategy isn't affected by leverage. If you expect that your system will work about 60 percent of the time, then that should hold no matter how much money is at stake or where that money came from. However, it's likely that it does make a difference to you on some subconscious level if you have borrowed the money.
Trading is very much a game of nerves. If you hesitate to make a trade, cut a loss, or otherwise follow your strategy, you're going to run into trouble.
Say you're trading futures and decide to accept three downticks before selling, and that you will look for five upticks before selling. This means you are willing to accept some loss, cut it if it gets out of hand, and then be disciplined about taking gains when you get them. This strategy keeps a lid on your losses while forcing some discipline on your gains.
Now, suppose you are dealing with lots and lots of leverage. Suddenly, those downticks become too real to you — it's money you don't have. Next thing you know, you only accept two downticks before closing out. But this keeps you from getting winners. Then you decide to ride with your winners, and suddenly you aren't taking profits fast enough, and your positions move against you. Your fear of loss is making you sloppy. That's why many traders find it better to borrow less money and stick to their system rather than borrow the maximum allowed and let that knowledge cloud their judgment.
Lenders can lose their nerve, too. Your brokerage firm might close your account because of losses, even though waiting just a little longer might turn a losing position into a profit.
5.12.2008
The Evolution of Day Trading
With the advent of the telegraph, stocktraders could receive daily price quotes. Many cities had bucket shops — storefront businesses where traders could bet on changes in stock and commodity prices. They weren't buying the security itself, but were instead placing bets against others. These schemes were highly prone to manipulation and fraud, and they were wiped out after the stock market crash of 1929.
After the 1929 crash, small investors could trade off the ticker tape, which was a printout of price changes sent by telegraph, or wire. They would normally do this by going down to their brokerage firm, sitting in a conference room, and placing orders based on the changes they saw on the tape. Really serious traders could get a wire installed in their own offices, but the costs were prohibitive for most individual investors. In any event, traders still had to place their orders through a broker rather than having direct access to the market, so they couldn't count on timely execution.
Another reason there was so little day trading back then is that all brokerage firms charged the same commissions until 1975. That year, the Securities and Exchange Commission (SEC) ruled that this amounted to price fixing. Brokers could then compete on their commissions. Some brokerage firms began allowing customers to trade stock at discount commission rates, which made active trading more profitable. (Some brokerage firms don't even charge commissions anymore — they get money from you in other ways, though.)
The system of trading off the ticker tape more or less persisted until the stock market crash of 1987. Flooded with orders, brokerage firms took care of their biggest customers first and pushed the smallest trades to the bottom of the pile. After the crash, the exchanges and the SEC made several changes that would reduce the chances of another crash and improve execution if one were to happen. One of those changes was the Small Order Entry System, often known as SOES, which gave orders of 1,000 shares or less priority over larger orders.
Then, in the 1990s, Internet access became widely available, and several networks started giving small traders direct access to price quotes and trading activities. This meant that traders could place orders on the same footing as the brokers they once had to work through. In fact, thanks to the SOES, the small traders had an advantage: They could place orders and then sell the stock to the larger firms, locking in a nice profit. Day trading looked like a pretty good way to make a living.
Your library and bookstore might have older books talking about how day traders can make easy money by exploiting SOES. That loophole is long gone, so stick to newer guides.
In 2000, the Small Order Execution System (SOES) was changed to eliminate the small traders' advantage, but few of them cared right away. More and more discount brokerage firms offered Internet trading while Internet stocks became wildly popular. No one needed SOES to make profits when Amazon.com and Webvan were going up in price every day. But then reality caught up with the technology industry, and the market for those stocks cratered in 2000.
We're now in a new era, with new trading practices and new regulation.
After the 1929 crash, small investors could trade off the ticker tape, which was a printout of price changes sent by telegraph, or wire. They would normally do this by going down to their brokerage firm, sitting in a conference room, and placing orders based on the changes they saw on the tape. Really serious traders could get a wire installed in their own offices, but the costs were prohibitive for most individual investors. In any event, traders still had to place their orders through a broker rather than having direct access to the market, so they couldn't count on timely execution.
Another reason there was so little day trading back then is that all brokerage firms charged the same commissions until 1975. That year, the Securities and Exchange Commission (SEC) ruled that this amounted to price fixing. Brokers could then compete on their commissions. Some brokerage firms began allowing customers to trade stock at discount commission rates, which made active trading more profitable. (Some brokerage firms don't even charge commissions anymore — they get money from you in other ways, though.)
The system of trading off the ticker tape more or less persisted until the stock market crash of 1987. Flooded with orders, brokerage firms took care of their biggest customers first and pushed the smallest trades to the bottom of the pile. After the crash, the exchanges and the SEC made several changes that would reduce the chances of another crash and improve execution if one were to happen. One of those changes was the Small Order Entry System, often known as SOES, which gave orders of 1,000 shares or less priority over larger orders.
Then, in the 1990s, Internet access became widely available, and several networks started giving small traders direct access to price quotes and trading activities. This meant that traders could place orders on the same footing as the brokers they once had to work through. In fact, thanks to the SOES, the small traders had an advantage: They could place orders and then sell the stock to the larger firms, locking in a nice profit. Day trading looked like a pretty good way to make a living.
Your library and bookstore might have older books talking about how day traders can make easy money by exploiting SOES. That loophole is long gone, so stick to newer guides.
In 2000, the Small Order Execution System (SOES) was changed to eliminate the small traders' advantage, but few of them cared right away. More and more discount brokerage firms offered Internet trading while Internet stocks became wildly popular. No one needed SOES to make profits when Amazon.com and Webvan were going up in price every day. But then reality caught up with the technology industry, and the market for those stocks cratered in 2000.
We're now in a new era, with new trading practices and new regulation.
When Day Traders Aren't Day Traders
By definition, day traders hold their investment positions for only a single day. This is important for a few reasons:
Closing out daily reduces your risk of something happening overnight.
Margin rates — the interest rates paid on money borrowed for trading — are low and in some cases zero for day traders, but the rates go up on overnight balances.
It's good trade discipline that can keep you from making expensive mistakes.
But like all rules, the single-day rule can be broken, and probably should be broken sometimes. The following sections show a few longer-term trading strategies that you may want to occasionally add to your trading business.
Swing trading: Holding for days
Swing trading involves holding a position for several days. Some swing traders hold overnight; others hold for days or even months. The longer time period gives more time for a position to work out, which is especially important if it is based on news events or if it requires taking a position contrary to the current market sentiment. Although swing trading gives traders more options for making a profit, it carries some risks because the position could turn against you while you are away from the markets.
There's always a tradeoff between risk and return. When you take more risk, you do so in the hopes of getting a greater return. But when you look for a way to increase return, remember that you will have to take on more risk to do it.
Position trading: Holding for weeks
A position trader holds a stake in a stock or a commodity for several weeks and possibly even for months. This person is attracted to the short-term price opportunities, but he also believes that he can make more money by holding the stake for a long enough period to see business fundamentals play out. This increases the risk and the potential return because a lot more can happen over months than can happen in minutes.
Investing: Holding for months or years
An investor is not a trader. Investors do careful research and buy a stake in an asset in the hopes of building a profit over the long term. It's not unusual for investors to hold assets for decades, although good ones sell quickly if they realize that they have made a mistake. (They want to cut their losses early, just as any good trader should.)
Investors are concerned about the prospects of the underlying business. Will it make money? Will it pay off its debts? Will it hold its value? They view short-term price fluctuations as noise rather than as profit opportunities.
Many traders pull out some of their profits to invest for the long term (or to give to someone else, such as a mutual fund manager or hedge fund, to invest). It's a way of building financial security in the pursuit of longer goals. This money is usually kept separate from the trading account.
Closing out daily reduces your risk of something happening overnight.
Margin rates — the interest rates paid on money borrowed for trading — are low and in some cases zero for day traders, but the rates go up on overnight balances.
It's good trade discipline that can keep you from making expensive mistakes.
But like all rules, the single-day rule can be broken, and probably should be broken sometimes. The following sections show a few longer-term trading strategies that you may want to occasionally add to your trading business.
Swing trading: Holding for days
Swing trading involves holding a position for several days. Some swing traders hold overnight; others hold for days or even months. The longer time period gives more time for a position to work out, which is especially important if it is based on news events or if it requires taking a position contrary to the current market sentiment. Although swing trading gives traders more options for making a profit, it carries some risks because the position could turn against you while you are away from the markets.
There's always a tradeoff between risk and return. When you take more risk, you do so in the hopes of getting a greater return. But when you look for a way to increase return, remember that you will have to take on more risk to do it.
Position trading: Holding for weeks
A position trader holds a stake in a stock or a commodity for several weeks and possibly even for months. This person is attracted to the short-term price opportunities, but he also believes that he can make more money by holding the stake for a long enough period to see business fundamentals play out. This increases the risk and the potential return because a lot more can happen over months than can happen in minutes.
Investing: Holding for months or years
An investor is not a trader. Investors do careful research and buy a stake in an asset in the hopes of building a profit over the long term. It's not unusual for investors to hold assets for decades, although good ones sell quickly if they realize that they have made a mistake. (They want to cut their losses early, just as any good trader should.)
Investors are concerned about the prospects of the underlying business. Will it make money? Will it pay off its debts? Will it hold its value? They view short-term price fluctuations as noise rather than as profit opportunities.
Many traders pull out some of their profits to invest for the long term (or to give to someone else, such as a mutual fund manager or hedge fund, to invest). It's a way of building financial security in the pursuit of longer goals. This money is usually kept separate from the trading account.
Focusing on Broad Financial Markets
You may think the foundation of the United States economy resides inside Fort Knox where the country holds its billions of dollars in gold, or possibly that it resides in our political center, Washington, D.C. Nope, it's neither of them. The country's true economic center is Wall Street, where billions of dollars change hands each and every day, thousands of companies are traded, and millions of people's lives are affected.
Stocks are not the only things sold in the broad financial markets. Every day, futures, options, and bonds also are traded. Here's a bird's-eve view of each type of market.
Stock markets
The stocks of almost every major U.S. corporation and many major foreign corporations are traded on a stock exchange in the United States each day, and none of the money involved in these trades goes directly into the companies being traded. Today numerous local and international stock exchanges trade stocks in publicly held corporations; moreover, the only major corporations not traded are those held privately — usually by families or original founding partners — that chose not to sell shares on the public market. Forbes magazine's top privately held corporation is Cargill. Mars, Bechtel, and Publix are three others on the Forbes top 20 list. Many of the large private corporations that are not traded publicly do have provisions for employee ownership of stock and must report earnings to the SEC, so they straddle the line of public versus private corporations.
A share of stock is actually a portion of ownership in a given company. Few stockholders own large enough stakes in a company to play a major role in decision-making. Instead, stockholders purchase stocks, hoping that their investments rise in price, so that those stocks can be sold at a profit some time in the future.
The three top stock exchanges in the United States are the New York Stock Exchange (NYSE), NASDAQ (the National Association of Securities Dealers Automated Quotation system), and the American Stock Exchange (Amex).
Futures markets
Futures trading actually started in Japan in the 18th century to trade rice and silk. This trading instrument was first used in the United States in the 1850s for trading grains and other agricultural entities. Basically, futures trading means establishing a financial contract in which you try to predict the future value of a commodity that must be delivered at a specific time in the future. Yup, if you had a working crystal ball, it would be very useful here. This type of trading is done on a commodities exchange. The largest such exchange in the United States today is the Chicago Mercantile Exchange. Commodities include any product that can be bought and sold. Oil, cotton, and minerals are just a few of the products sold on a commodity exchange.
Futures contracts must have a seller (usually the person producing the commodity, a farmer or oil refinery, for example) and a buyer (usually a consumer). You also can speculate on either side of the contract, basically meaning:
When you buy a futures contract, you're agreeing to buy a commodity that is not yet ready for sale or hasn't yet been produced at a set price at a specific time in the future.
When you sell a futures contact, you're agreeing to provide a commodity that is not yet ready for sale or hasn't yet been produced at a set price at a specific time in the future.
The futures contract states the price at which you agree to pay for or sell a certain amount of this future product when it's delivered at a specific future date. Although most futures contracts are based on a physical commodity, some futures contracts also are sold based on the future value of stock indexes.
Unless you're a commercial consumer who plans to use the commodity, you won't actually take delivery of or actually provide the commodity for which you're trading a futures contract. You'll more than likely sell the futures contract you bought before you actually have to accept the commodity from a commercial customer. Futures contracts are used as financial instruments by producers, consumers, and speculators.
Bond markets
Bonds are actually loan instruments. Companies sell bonds to borrow cash. If you buy a bond, you're essentially holding a company's debt or the debt of a governmental entity. The company or government entity that sells the bond agrees to pay you a certain amount of interest for a specific period of time in exchange for the use of your money. The big difference between stocks and bonds is that bonds are debt obligations and stocks are equity. Stockholders actually own a share of the corporation. Bondholders lend money to the company with no right of ownership. Bonds, however, are considered safer, because if a company files bankruptcy, bondholders are paid before stockholders. Bonds are a safety net and not actually a part of the trading world for position traders, day traders, and swing traders. While a greater dollar volume of bonds is traded each day, the primary traders for this venue are large dollar institutional traders.
Options markets
An option is a contract that gives the buyer the right, but not the obligation, either to buy or to sell the asset upon which it is based at a price specified in the contract on or before a date specified in the contract. Sometime before the options period expires, a purchaser of an option must decide whether to exercise the option and buy (or sell) the asset (most commonly stocks) at the target price. If the options buyer decides not to buy (or sell) the asset, his or her initial investment in the option is lost. Options also are called derivatives.
Stocks are not the only things sold in the broad financial markets. Every day, futures, options, and bonds also are traded. Here's a bird's-eve view of each type of market.
Stock markets
The stocks of almost every major U.S. corporation and many major foreign corporations are traded on a stock exchange in the United States each day, and none of the money involved in these trades goes directly into the companies being traded. Today numerous local and international stock exchanges trade stocks in publicly held corporations; moreover, the only major corporations not traded are those held privately — usually by families or original founding partners — that chose not to sell shares on the public market. Forbes magazine's top privately held corporation is Cargill. Mars, Bechtel, and Publix are three others on the Forbes top 20 list. Many of the large private corporations that are not traded publicly do have provisions for employee ownership of stock and must report earnings to the SEC, so they straddle the line of public versus private corporations.
A share of stock is actually a portion of ownership in a given company. Few stockholders own large enough stakes in a company to play a major role in decision-making. Instead, stockholders purchase stocks, hoping that their investments rise in price, so that those stocks can be sold at a profit some time in the future.
The three top stock exchanges in the United States are the New York Stock Exchange (NYSE), NASDAQ (the National Association of Securities Dealers Automated Quotation system), and the American Stock Exchange (Amex).
Futures markets
Futures trading actually started in Japan in the 18th century to trade rice and silk. This trading instrument was first used in the United States in the 1850s for trading grains and other agricultural entities. Basically, futures trading means establishing a financial contract in which you try to predict the future value of a commodity that must be delivered at a specific time in the future. Yup, if you had a working crystal ball, it would be very useful here. This type of trading is done on a commodities exchange. The largest such exchange in the United States today is the Chicago Mercantile Exchange. Commodities include any product that can be bought and sold. Oil, cotton, and minerals are just a few of the products sold on a commodity exchange.
Futures contracts must have a seller (usually the person producing the commodity, a farmer or oil refinery, for example) and a buyer (usually a consumer). You also can speculate on either side of the contract, basically meaning:
When you buy a futures contract, you're agreeing to buy a commodity that is not yet ready for sale or hasn't yet been produced at a set price at a specific time in the future.
When you sell a futures contact, you're agreeing to provide a commodity that is not yet ready for sale or hasn't yet been produced at a set price at a specific time in the future.
The futures contract states the price at which you agree to pay for or sell a certain amount of this future product when it's delivered at a specific future date. Although most futures contracts are based on a physical commodity, some futures contracts also are sold based on the future value of stock indexes.
Unless you're a commercial consumer who plans to use the commodity, you won't actually take delivery of or actually provide the commodity for which you're trading a futures contract. You'll more than likely sell the futures contract you bought before you actually have to accept the commodity from a commercial customer. Futures contracts are used as financial instruments by producers, consumers, and speculators.
Bond markets
Bonds are actually loan instruments. Companies sell bonds to borrow cash. If you buy a bond, you're essentially holding a company's debt or the debt of a governmental entity. The company or government entity that sells the bond agrees to pay you a certain amount of interest for a specific period of time in exchange for the use of your money. The big difference between stocks and bonds is that bonds are debt obligations and stocks are equity. Stockholders actually own a share of the corporation. Bondholders lend money to the company with no right of ownership. Bonds, however, are considered safer, because if a company files bankruptcy, bondholders are paid before stockholders. Bonds are a safety net and not actually a part of the trading world for position traders, day traders, and swing traders. While a greater dollar volume of bonds is traded each day, the primary traders for this venue are large dollar institutional traders.
Options markets
An option is a contract that gives the buyer the right, but not the obligation, either to buy or to sell the asset upon which it is based at a price specified in the contract on or before a date specified in the contract. Sometime before the options period expires, a purchaser of an option must decide whether to exercise the option and buy (or sell) the asset (most commonly stocks) at the target price. If the options buyer decides not to buy (or sell) the asset, his or her initial investment in the option is lost. Options also are called derivatives.
Looking at Major Stock Market Indexes
So you invest in stocks to share in the spoils of capitalistic economies. When you invest in stocks, you do so through the stock market. What is the stock market? Everybody talks about "The Market" the same way they do a close personal friend:
"The Market is down 137 points today."
"With The Market hitting new highs, isn't now a bad time to invest in The Market?"
"The Market seems ready for a fall."
When people talk about The Market, they're usually referring to the U.S. stock market. Even more specifically, they're speaking about the Dow Jones Industrial Average, created by Charles Dow and Eddie Jones. Dow and Jones, two reporters in their 30s, started publishing a paper that you may have heard of — The Wall Street Journal — in 1889. Like its modern-day version, the nineteenth-century Wall Street Journal reported current financial news. Dow and Jones also compiled stock prices of larger, important companies and created and calculated indexes to track the performance of the U.S. stock market.
The Dow Jones Industrial Average (DJIA) market index tracks the performance of 30 large companies that are headquartered in the United States. The Dow 30 includes companies such as telecommunications giant AT&T, airplane manufacturer Boeing, soda maker Coca-Cola, oil giant Exxon Mobil, automaker General Motors, technology behemoths IBM, Intel and Microsoft, fast food king McDonald's, and retailers Home Depot and Wal-Mart.
The 30 stocks that make up the Dow aren't the 30 largest or the 30 best companies in America. They just so happen to be the 30 companies that senior staff members at The Wall Street Journal think reflect the diversity of the economy in the United States. Some criticize the Dow index for encompassing so few companies and for a lack of diversity. The 30 stocks in the Dow change over time as companies merge, decline, and rise in importance.
But just as New York isn't the only city to live in, the 30 stocks in the Dow Jones Industrial Average are far from representative of all the different types of stocks that you can invest in. Here are some other important market indexes and the types of stocks that they track:
Standard & Poor's 500. Like the Dow Jones Industrial Average, the S&P 500 tracks the performance of larger-company U.S. stocks. As the name S&P 500 suggests, this index tracks the prices of 500 stocks. These 500 big companies account for nearly 80 percent of the total market value of the tens of thousands of stocks traded in the United States. Thus, the S&P 500 is a much broader and more representative index of the larger company stocks in the United States than is the Dow Jones Industrial Average.
Unlike the Dow index, which is largely calculated by adding the current share price of each of its component stocks, the S&P 500 index is calculated by adding the total market value (capitalization) of its component stocks. To impress your friends and colleagues, you can discuss with them that the S&P 500 is a capitalization-weighted index.
Russell 2000. This index tracks the performance of 2,000 smaller U.S. company stocks of varying industries. While over the longer term small company stocks tend to move in tandem with larger company stocks, it's not unusual for one to rise or fall more than the other or for one index to fall while the other rises in a given year. For example, in 2001, the Russell 2000 actually rose 2.5 percent while the S&P 500 fell 11.9 percent. Be aware that smaller company stocks tend to be more volatile.
Wilshire 5000. Despite its name, the Wilshire 5000 index actually tracks the prices of more than 6,500 stocks of U.S. companies of all sizes — small, medium, and large. Thus, many consider this index the broadest and most representative of the overall U.S. stock market.
Morgan Stanley EAFE. Stocks don't exist only in the United States. Morgan Stanley's EAFE index (EAFE stands for Europe, Australasia, and Far East) tracks the prices of stocks in the other major developed countries of the world.
Morgan Stanley Emerging Markets. This index follows the price movements of stocks in the less economically developed but "emerging" countries, which usually concentrate in Southeast Asia and Latin America. These stock markets tend to be more volatile than those in established economies. During good economic times, emerging markets usually reward investors with higher returns, but stocks can plunge farther and faster than stocks in developed markets.
Conspicuously absent from this list of major stock market indexes is the NASDAQ index. With the boom in technology stock prices in the late 1990s, CNBC and other financial media started broadcasting movements in the technology-laden NASDAQ index, thereby increasing investor interest and the frenzy surrounding technology stocks. Many experts aren't fans of sector (industry) specific investing; it undermines diversification and places you in the role of a professional money manager in having to determine when and how much to invest in specific industry groups. You might consider ignoring the NASDAQ as well as other industry-concentrated indexes.
"The Market is down 137 points today."
"With The Market hitting new highs, isn't now a bad time to invest in The Market?"
"The Market seems ready for a fall."
When people talk about The Market, they're usually referring to the U.S. stock market. Even more specifically, they're speaking about the Dow Jones Industrial Average, created by Charles Dow and Eddie Jones. Dow and Jones, two reporters in their 30s, started publishing a paper that you may have heard of — The Wall Street Journal — in 1889. Like its modern-day version, the nineteenth-century Wall Street Journal reported current financial news. Dow and Jones also compiled stock prices of larger, important companies and created and calculated indexes to track the performance of the U.S. stock market.
The Dow Jones Industrial Average (DJIA) market index tracks the performance of 30 large companies that are headquartered in the United States. The Dow 30 includes companies such as telecommunications giant AT&T, airplane manufacturer Boeing, soda maker Coca-Cola, oil giant Exxon Mobil, automaker General Motors, technology behemoths IBM, Intel and Microsoft, fast food king McDonald's, and retailers Home Depot and Wal-Mart.
The 30 stocks that make up the Dow aren't the 30 largest or the 30 best companies in America. They just so happen to be the 30 companies that senior staff members at The Wall Street Journal think reflect the diversity of the economy in the United States. Some criticize the Dow index for encompassing so few companies and for a lack of diversity. The 30 stocks in the Dow change over time as companies merge, decline, and rise in importance.
But just as New York isn't the only city to live in, the 30 stocks in the Dow Jones Industrial Average are far from representative of all the different types of stocks that you can invest in. Here are some other important market indexes and the types of stocks that they track:
Standard & Poor's 500. Like the Dow Jones Industrial Average, the S&P 500 tracks the performance of larger-company U.S. stocks. As the name S&P 500 suggests, this index tracks the prices of 500 stocks. These 500 big companies account for nearly 80 percent of the total market value of the tens of thousands of stocks traded in the United States. Thus, the S&P 500 is a much broader and more representative index of the larger company stocks in the United States than is the Dow Jones Industrial Average.
Unlike the Dow index, which is largely calculated by adding the current share price of each of its component stocks, the S&P 500 index is calculated by adding the total market value (capitalization) of its component stocks. To impress your friends and colleagues, you can discuss with them that the S&P 500 is a capitalization-weighted index.
Russell 2000. This index tracks the performance of 2,000 smaller U.S. company stocks of varying industries. While over the longer term small company stocks tend to move in tandem with larger company stocks, it's not unusual for one to rise or fall more than the other or for one index to fall while the other rises in a given year. For example, in 2001, the Russell 2000 actually rose 2.5 percent while the S&P 500 fell 11.9 percent. Be aware that smaller company stocks tend to be more volatile.
Wilshire 5000. Despite its name, the Wilshire 5000 index actually tracks the prices of more than 6,500 stocks of U.S. companies of all sizes — small, medium, and large. Thus, many consider this index the broadest and most representative of the overall U.S. stock market.
Morgan Stanley EAFE. Stocks don't exist only in the United States. Morgan Stanley's EAFE index (EAFE stands for Europe, Australasia, and Far East) tracks the prices of stocks in the other major developed countries of the world.
Morgan Stanley Emerging Markets. This index follows the price movements of stocks in the less economically developed but "emerging" countries, which usually concentrate in Southeast Asia and Latin America. These stock markets tend to be more volatile than those in established economies. During good economic times, emerging markets usually reward investors with higher returns, but stocks can plunge farther and faster than stocks in developed markets.
Conspicuously absent from this list of major stock market indexes is the NASDAQ index. With the boom in technology stock prices in the late 1990s, CNBC and other financial media started broadcasting movements in the technology-laden NASDAQ index, thereby increasing investor interest and the frenzy surrounding technology stocks. Many experts aren't fans of sector (industry) specific investing; it undermines diversification and places you in the role of a professional money manager in having to determine when and how much to invest in specific industry groups. You might consider ignoring the NASDAQ as well as other industry-concentrated indexes.
Buying Stock on Margin
Margin means buying securities, such as stocks, by using funds you borrow from your broker. Buying stock on margin is similar to buying a house with a mortgage. If you buy a house at a purchase price of $100,000 and put 10 percent down, your equity (the part you own) is $10,000, and you borrow the remaining $90,000 with a mortgage. If the value of the house rises to $120,000 and you sell, you will make a profit of 100 percent (closing costs excluded). How is that? The $20,000 gain on the property represents a gain of 20 percent on the purchase price of $100,000, but because your real investment is $10,000 (the down payment), your gain works out to 200 percent (a gain of $20,000 on your initial investment of $10,000).
Buying on margin is an example of using leverage to maximize your gain when prices rise. Leverage is simply using borrowed money to increase your profit. This type of leverage is great in a favorable (bull) market, but it works against you in an unfavorable (bear) market. Say that a $100,000 house you purchase with a $90,000 mortgage falls in value to $80,000 (and property values can decrease during economic hard times). Your outstanding debt of $90,000 exceeds the value of the property. Because you owe more than you own, it is negative net worth. Leverage is a double-edged sword.
Marginal outcomes
Suppose that you think that the stock for the company Mergatroid, Inc., currently at $40 per share, will go up in value. You want to buy 100 shares, but you have only $2,000. What can you do? If you're intent on buying 100 shares (versus simply buying the 50 shares that you have cash for), you can borrow the additional $2,000 from your broker on margin. If you do that, what are the potential outcomes?
If the stock price goes up
This is the best outcome for you. If Mergatroid goes to $50 per share, your investment will be worth $5,000, and your outstanding margin loan will be $2,000. If you sell, the total proceeds will pay off the loan and leave you with $3,000. Because your initial investment was $2,000, your profit is a solid 50 percent because ultimately your $2,000 principal amount generated a $1,000 profit. However, if you pay the entire $4,000 upfront — without the margin loan — your $4,000 investment will generate a profit of $1,000, or 25 percent. Using margin, you will double the return on your money.
Leverage, when used properly, is very profitable. However, it is still debt, so understand that you must pay it off eventually.
If the stock price fails to rise
If the stock goes nowhere, you still have to pay interest on that margin loan. If the stock pays dividends, this money can defray some of the cost of the margin loan. In other words, dividends can help you pay off what you borrow from the broker.
Having the stock neither rise nor fall may seem like a neutral situation, but you pay interest on your margin loan with each passing day. For this reason, margin trading can be a good consideration for conservative investors if the stock pays a high dividend. Many times, a high dividend from $5,000 worth of stock can exceed the margin interest you have to pay from the $2,500 (50 percent) you borrow from the broker to buy that stock.
If the stock price goes down, buying on margin can work against you. What if Mergatroid goes to $38 per share? The market value of 100 shares will be $3,800, but your equity will shrink to only $1,800 because you have to pay your $2,000 margin loan. You're not exactly looking at a disaster at this point, but you'd better be careful, because the margin loan exceeds 50 percent of your stock investment. If it goes any lower, you may get the dreaded margin call, when the broker actually contacts you to ask you to restore the ratio between the margin loan and the value of the securities.
Maintaining your balance
When you purchase stock on margin, you must maintain a balanced ratio of margin debt to equity of at least 50 percent. If the debt portion exceeds this limit, then you'll be required to restore that ratio by depositing either more stock or more cash into your brokerage account. The additional stock you deposit can be stock that's transferred from another account.
If, for example, Mergatroid goes to $28 per share, the margin loan portion exceeds 50 percent of the equity value in that stock — in this case, because the market value of your stock is $2,800 but the margin loan is still at $2,000. The margin loan is a worrisome 71 percent of the market value ($2,000 divided by $2,800 = 71 percent). Expect to get a call from your broker to put more securities or cash into the account to restore the 50 percent balance.
If you can't come up with more stock, other securities, or cash, then the next step is to sell stock from the account and use the proceeds to pay off the margin loan. For you, it means realizing a capital loss — you lost money on your investment.
The Federal Reserve Board governs margin requirements for brokers with Regulation T. Discuss this rule with your broker to understand fully your (and the broker's) risks and obligations. Regulation T dictates the minimum percentage that margin should be set at. For most listed stocks, it is 50 percent.
Margin, as you can see, can escalate your profits on the up side but magnify your losses on the down side. If your stock plummets drastically, you can end up with a margin loan that exceeds the market value of the stock you used the loan to purchase. In the emerging bear market of 2000, many people were hurt by stock losses, and a large number of these losses were made worse because people didn't manage the responsibilities involved with margin trading.
If you buy stock on margin, use a disciplined approach. Be extra careful when using leverage, such as a margin loan, because it can backfire. Keep the following points in mind:
Have ample reserves of cash or marginable securities in your account. Try to keep the margin ratio at 40 percent or less to minimize the chance of a margin call.
If you're a beginner, consider using margin to buy stock in large companies that have a relatively stable price and pay a good dividend. Some people buy income stocks that have dividend yields that exceed the margin interest rate, meaning that the stock ends up paying for its own margin loan. Just remember those stop orders.
Constantly monitor your stocks. If the market turns against you, the result will be especially painful if you use margin.
Have a payback plan for your margin debt. Margin loans against your investments mean that you're paying interest. Your ultimate goal is to make money, and paying interest eats into your profits.
Buying on margin is an example of using leverage to maximize your gain when prices rise. Leverage is simply using borrowed money to increase your profit. This type of leverage is great in a favorable (bull) market, but it works against you in an unfavorable (bear) market. Say that a $100,000 house you purchase with a $90,000 mortgage falls in value to $80,000 (and property values can decrease during economic hard times). Your outstanding debt of $90,000 exceeds the value of the property. Because you owe more than you own, it is negative net worth. Leverage is a double-edged sword.
Marginal outcomes
Suppose that you think that the stock for the company Mergatroid, Inc., currently at $40 per share, will go up in value. You want to buy 100 shares, but you have only $2,000. What can you do? If you're intent on buying 100 shares (versus simply buying the 50 shares that you have cash for), you can borrow the additional $2,000 from your broker on margin. If you do that, what are the potential outcomes?
If the stock price goes up
This is the best outcome for you. If Mergatroid goes to $50 per share, your investment will be worth $5,000, and your outstanding margin loan will be $2,000. If you sell, the total proceeds will pay off the loan and leave you with $3,000. Because your initial investment was $2,000, your profit is a solid 50 percent because ultimately your $2,000 principal amount generated a $1,000 profit. However, if you pay the entire $4,000 upfront — without the margin loan — your $4,000 investment will generate a profit of $1,000, or 25 percent. Using margin, you will double the return on your money.
Leverage, when used properly, is very profitable. However, it is still debt, so understand that you must pay it off eventually.
If the stock price fails to rise
If the stock goes nowhere, you still have to pay interest on that margin loan. If the stock pays dividends, this money can defray some of the cost of the margin loan. In other words, dividends can help you pay off what you borrow from the broker.
Having the stock neither rise nor fall may seem like a neutral situation, but you pay interest on your margin loan with each passing day. For this reason, margin trading can be a good consideration for conservative investors if the stock pays a high dividend. Many times, a high dividend from $5,000 worth of stock can exceed the margin interest you have to pay from the $2,500 (50 percent) you borrow from the broker to buy that stock.
If the stock price goes down, buying on margin can work against you. What if Mergatroid goes to $38 per share? The market value of 100 shares will be $3,800, but your equity will shrink to only $1,800 because you have to pay your $2,000 margin loan. You're not exactly looking at a disaster at this point, but you'd better be careful, because the margin loan exceeds 50 percent of your stock investment. If it goes any lower, you may get the dreaded margin call, when the broker actually contacts you to ask you to restore the ratio between the margin loan and the value of the securities.
Maintaining your balance
When you purchase stock on margin, you must maintain a balanced ratio of margin debt to equity of at least 50 percent. If the debt portion exceeds this limit, then you'll be required to restore that ratio by depositing either more stock or more cash into your brokerage account. The additional stock you deposit can be stock that's transferred from another account.
If, for example, Mergatroid goes to $28 per share, the margin loan portion exceeds 50 percent of the equity value in that stock — in this case, because the market value of your stock is $2,800 but the margin loan is still at $2,000. The margin loan is a worrisome 71 percent of the market value ($2,000 divided by $2,800 = 71 percent). Expect to get a call from your broker to put more securities or cash into the account to restore the 50 percent balance.
If you can't come up with more stock, other securities, or cash, then the next step is to sell stock from the account and use the proceeds to pay off the margin loan. For you, it means realizing a capital loss — you lost money on your investment.
The Federal Reserve Board governs margin requirements for brokers with Regulation T. Discuss this rule with your broker to understand fully your (and the broker's) risks and obligations. Regulation T dictates the minimum percentage that margin should be set at. For most listed stocks, it is 50 percent.
Margin, as you can see, can escalate your profits on the up side but magnify your losses on the down side. If your stock plummets drastically, you can end up with a margin loan that exceeds the market value of the stock you used the loan to purchase. In the emerging bear market of 2000, many people were hurt by stock losses, and a large number of these losses were made worse because people didn't manage the responsibilities involved with margin trading.
If you buy stock on margin, use a disciplined approach. Be extra careful when using leverage, such as a margin loan, because it can backfire. Keep the following points in mind:
Have ample reserves of cash or marginable securities in your account. Try to keep the margin ratio at 40 percent or less to minimize the chance of a margin call.
If you're a beginner, consider using margin to buy stock in large companies that have a relatively stable price and pay a good dividend. Some people buy income stocks that have dividend yields that exceed the margin interest rate, meaning that the stock ends up paying for its own margin loan. Just remember those stop orders.
Constantly monitor your stocks. If the market turns against you, the result will be especially painful if you use margin.
Have a payback plan for your margin debt. Margin loans against your investments mean that you're paying interest. Your ultimate goal is to make money, and paying interest eats into your profits.
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