The Impact of Expenses on Your Returns

Check this out. Below is a summary of two portfolios I have been tracking. These portfolios are invested in EXACTLY the same thing with EXACTLY the same allocation. Yet, Portfolio A has had an average annual rate of return of 11.00% compared to Portfolio B’s 12.67%:

So, what accounts for the difference?

Portfolio A started out with $10,000 while Portfolio B started out with $100,000, while the account fee stayed the same ($199).

The account fee stayed the same because I’m simulating these portfolios using FOLIOfn‘s fee structure. Naturally, as the portfolio grows, the smaller the fee becomes as a percentage of the account value, which increases the net return.

There’s not a lot that can be done about this. Sure, you could probably find a cheaper brokerage firm (something I’ll go into later). For the most part, investors with smaller account values just have to suck it up and work on growing their portfolios. I definitely wouldn’t let this stop me from investing.

How an Interest-Only Mortgage Works

Let’s say you want to buy a house and will need to finance it with a $200,000 mortgage. You meet with a mortgage broker and they show you two loans: a 30-year fixed rate mortgage at 6.30% and a 30-year fixed rate mortgage with an interest-only period of 15 years (also at 6.30%). How do you compare these two mortgages?

30-Year Fixed-Rate Mortgage

Using this calculator, you can see that the payment on a $200,000, 30-year fixed rate mortgage at 6.30% would be $1,238 (or $1,237.95 to be exact). Beginning with the very first payment, a very small portion of the payment will go towards the principal of the loan and a very BIG portion of the payment will go to pay interest as the graphic below shows:

Notice that the beginning balance for the second month is smaller than the beginning balance from the previous month. That’s because a portion of your payment is going towards the principal. As you continue to pay on your mortgage, the percentage of each payment that goes towards interest will decrease while the amount going towards the principal will increase. Towards the end of the mortgage term, most of the payment will go towards principal and very little will go towards interest. For more on how the math of a mortgage works, see this post I wrote last year.

Pretty simple stuff. Now let’s look at an interest-only mortgage.

30-Year Fixed Rate Mortgage With a 15-Year Interest-Only Period

An interest-only loan is essentially two loans rolled into one. For example: a 30-year fixed rate mortgage with a 15-year interest-only period works out to two 15-year loans. As we calculated in the first example, the interest amount on the first payment is $1,050. With an interest-only mortgage, your initial payment would be $1,050, which is $187.95 smaller than the traditional payment:

Notice that because all you are paying is interest, your loan amount stays the same. In other words, you pay each month but you don’t make any progress on actually paying off the loan. This would continue for 180 payments (15 years). At the end of 15 years, you will still owe $200,000 on your mortgage. In order to pay off that mortgage in the next 15 years, you will have to pay substantially more each month. How much more? Well, you can calculate it yourself using this calculator. For the input, use 15 years, 6.30% interest rate, $200,000 for amount borrowed. You should get $1,720 ($1,720.30 to be precise) or $670 MORE per month! You’ll then have to pay $1,720 per month for the next 15 years (180 months).

What About Equity?

Equity in a house comes from two sources:

1. The amount of each payment that goes towards principal. At the end of 15 years, the traditional mortgage would have built up an equity position of $56,078. You would have built no equity position from payments with the IO mortgage.

2. The appreciation in the value of the home. In the example, if the home appreciates at 3% per year, at the end of 15 years, it will be worth $311,594.

With the traditional 30-year fixed mortgage, at the end of 15 years, you will have an equity position of $167,672 [$56,078 equity built up in the mortgage + $111,594 appreciation in the value of the home). With the IO mortgage, your equity-position will just be the increase in the value of the home ($111,594). NOTE: There’s NO GUARANTEE that the house will appreciate in value. Some areas of the U.S. have experienced price declines, which put some people in negative equity positions (not a good thing!).

At the End of 30 Years

As you can see from the graphic below, the interest-only mortgage carries with it significantly more in interest charges. However, this doesn’t tell the whole story as it leaves out the potential growth in the payment difference and the tax deductibility of the interest (more on this in a future post).

At first glance, the IO mortgage does not appear to be that great of a deal. You’re only “saving” $187 per month and that only lasts for a while. If you can’t afford the $187 difference, should you be buying the house? Good question.

More on this later…

Anyone Out There a Member of the American Association of Individual Investors (AAII)?

I’m curious – are any of you a member of the American Association of Individual Investors (or AAII as it is called)? If so, what has been your experience? Is it worth the membership fee? I have received numberous offers from AAII over the years but have never joined. The letter I received today had a rather interesting opening:

If You Want to Be a Successful Individual Investor, You Should Know

  • Why you shouldn’t buy any stock in the S&P 500 Index!
  • Why the asset allocation rules you read about are nonsense!
  • Why you should avoid the majority of mutual funds!
  • Why international diversification doesn’t work!
  • Why “risky” stocks are often not risky!

If that doesn’t pique your interest, I don’t know what would.

Anyway, if you are a member of AAII, I want to hear from you.

Don’t Buy a Computer From BlueHippo!

Foobarista sent me an email yesterday telling me about a company called BlueHippo, which “sells” computers to people without a credit check. All you have to do is pay a set up fee of $99.00 and then pay their “low” weekly payments for 52 weeks and the computer is yours. Oh, and if you pay for 13 consecutive weeks, they’ll help you out by “financing” the remainder of your balance for you. I have no idea what those financing terms are, but if they are anything like the price of their computers, I’m sure they are horrible!

Here’s an example of what I’m talking about:

Here’s one of the computers that BlueHippo is currently offering:

Blue Hippo Computer

So, you have to pay over $1,200 for this machine and it DOES NOT include a monitor! Not only that, this computer is out of date. A 40 gig hard drive? Come on! Just to give you something to compare this to, I went to the HP website and found this computer:

HP 1510y Series

This price DOES include a 15-inch flat panel monitor as well as a 160 gig hard drive and a few other upgrades.

So, if you could afford to save up $21.99 per week, the MUCH BETTER HP 1510y computer could be yours in 38 weeks and that’s without the $99 up-front fee!

If you have bad credit or are low on funds, the ONLY way you will ever get ahead is to avoid companies like BlueHippo and rent-to-own companies, that disguise themselves as “helpers” but are really wolves in sheep’s clothing. On other words: save up first, then buy!

The Biggest Website You’ve Probably Never Heard of!

Every morning I cruise my Bloglines account to find new and interesting stories to share with you. Today I found a story about a website called Photobucket, which is a place for people to “house” their photos and videos which they can then link to from their blogs or MySpace pages. What I found fascinating was the fact that Photobucket has over 38 MILLION members and it is adding 80,000 members per day! Wow! Oh, and Photobucketgets more than double the traffic of Flickr.

I hadn’t heard of Photobucket until this morning!

Magic Formula Investing Update – 2nd “Purchase”

I meant to do this earlier this month but forgot about it.

As discussed in an earlier post, I’m going to follow a hypothetical post using the Magic Formula found in Joel Greenblatt’s The Little Book That Beats The Market.

Following the procedure in the first post, I re-ran the numbers and came up with the following list:

Magic Formula Investing

I’m ignoring the stocks (those listed in red) that were picked in the previous session. That leaves the stocks highlighted in gray. I’ll add them to the portfolio using today’s closing prices and post the results tomorrow morning. As of right now, the portfolio is doing pretty good. The investment portion is up over 10% since the portfolio was put together on January 5, 2007. For more information, check out this graphic.

Got Any Gold In Your Closet?

Check out this article (free) I found in the Wall Street Journal. Savvy shoppers are buying clothing and purses at places like Target and then reselling them on eBay for huge profits. Check this out:

That’s a 628.8% return in one month! Wow!

Of course things like this aren’t without risks. For one, you have to know which items are going to be in demand and which ones are going to be hard to find. However, I’m sure a few lucky people will make some money off this little craze.