Balancing With Bonds

Question of the week:With the stock market so volatile lately, I'm considering bonds. I've never invested in them before, so can you give me some guidance to get started? --GT

Dear GT,

As you know, two of the basic investment choices are stocks and bonds. Stocks offer you the best long-term growth potential, while bonds give your portfolio some stability. It's the classic tradeoff between risk and return, and the trick is determining what proportion of each is right for your situation.

In general, I believe that most investors who have time horizons of at least five to ten years can afford to be completely in stocks--unless they just can't stomach the volatility that an all-stock portfolio has these days. In that case, a small percentage of bonds will help a good bit in smoothing out those swings.

Here's how one member of the Armchair Millionaire community uses bonds for balance:

"I've always had a couple of balanced mutual funds that were each about 30 percent bonds, so my overall portfolio has been 10-15 percent bonds for the last five years or so. It helped a lot over the last three years. I have friends who have lost three-fourths of their portfolios because they were entirely in aggressive growth mutual funds. I haven't experienced anything like that kind of loss." --IMF

If you decide that bonds are right for you, my guide will give you a quick introduction to the subject.

The Armchair Millionaire Guide to Bonds

• The basics. When you buy a bond, you receive periodic interest payments over the life of the bond. When it matures (maturities range all the way from one day to 30 years), you'll receive the face value of the bond back. The actual return on your investment is called the yield.

• Types. Bonds fall into three major categories:
  • Treasury bonds (and bills and notes), are issued by the U.S. government and backed up by its full faith and credit--you never have to worry about the U.S. not paying you back if you buy some of its bonds.
  • Municipal bonds are issued by state and local governments and are attractive because their interest is exempt from federal and sometimes state and local income tax.
  • Corporate bonds are issued by companies. These bonds usually offer higher yields than other types because there is generally more risk involved--companies are more likely to run into financial problems than the federal or local governments.

• Risks. Bonds are not necessarily the "safe" investment that many people assume. They do carry risks, some kinds much more than others. Here are some of the risks inherent in bond investing:
  • Inflation risk. Inflation can erode a bond's value over time. Bonds with the longest maturities are the most subject to inflation risk.
  • Interest rate risk. When interest rates go up or down, the prices of bonds are directly affected.
  • Market risk. Bonds follow the laws of supply and demand just like any other investment, and their prices can rise and fall accordingly.
  • Credit risk. Aside from U.S. Treasury bonds, there is always a risk that the issuer of a bond may fail to repay its debt. Two well-known companies--Standard & Poor's and Moody's--rate the credit of most bond issuers, so you can have a clear idea in advance of their creditworthiness.

• Where to buy. You can buy government bonds directly from the U.S. Treasury, or you can buy bonds of all kinds through many brokers, including most online brokers. If you want to own bonds but don't want the hassle of buying and selling them yourself, there is also a wide range of bond mutual funds available.

THE BOTTOM LINE: For long-range growth, you can't top stocks, so keep your portfolio tilted in that direction as much as you possibly can. When you need a little balance, or are getting closer to needing the money in your portfolio, add a small portion of bonds.

A Better Deal:Refinancing Your Mortgage

Question of the week:I want to refinance my mortgage before rates go up again, but there are a few different kinds of mortgages and I'm not sure which one is best. Any advice? --Ben G.

Dear Ben,

With mortgage interest rates at lows that haven't been seen in two generations, you've got plenty of company in your rush to refinance. When we asked members of the Armchair Millionaire community about how much money they're saving by refinancing, we could almost hear the glee. Here are a couple of examples:

"Just refinanced the house with a similar payment as in the past but we will save ten years of payments and tons of interest!" --de losangeles

"I refinanced two months ago, taking me from a 4-year adjustable to a 6.25% 30-year fixed with no points or pre-payment penalty. This saves me $140 per month after the cost of the refinance is recouped." --Kevin

There are several different reasons to refinance, and you should know exactly what you want to get from the refinance in order to choose your best loan option. These are main reasons people are refinancing:

• To reduce monthly payments. By lowering your interest rate, not only will your payment drop, you'll also build up equity a bit faster.
• To shorten the term. Many people are switching from a 30-year to a 15-year loan. Your monthly payment will go up, but you'll pay much less interest overall and be mortgage-free much sooner.
• To tap into equity. "Cash-out" refinances allow you to pay off the old mortgage, plus obtain cash. They're used by many people to pay for home improvement, college or other major expenses.
• To switch from an adjustable-rate to a fixed-rate. If you took out an adjustable rate mortgage when interest rates were higher, you might want to switch now to the predictability of a fixed-rate loan.

Once you decide which option is right for you, make sure you get the best deal. My quick guide tells you the key things you should know.

The Armchair Millionaire Guide to Refinancing Your Mortgage

• Know the terms. In a fixed-rate mortgage, the interest rate will not change-and your payments will remain constant-for the life of the loan, typically 30 or 15 years. They're a good idea when interest rates are low, or whenever you want the security of knowing exactly what your payments will be. In an adjustable-rate mortgage (ARM), the interest rate starts out lower than comparable fixed-rate loans, but is adjusted (either up or down) periodically as market interest rates change. ARMs are enticing when interest rates are high and people figure that rates are only likely to go down in the future.

• Know the APR. Lenders are required to tell you the APR (short for "annual percentage rate") to make it easier for you to compare two different loans. While the interest rate tells you only interest charged on the loan amount, the APR also takes into account many of the costs of the loan, such as points, lender fees and mortgage insurance. I regard the APR as a much more realistic number than the interest rate.

• Know the points. A point is simply a fee that is one percent of the loan amount. It can get confusing, however, because there are actually two kinds of points. Discount points are a fee you pay up -front in order to lower the interest rate of your loan. Origination points are a fee charged by the lender to help cover their costs. Avoid origination points if at all possible; consider discount points if they make sense for your situation.

• Know the costs. Some costs are unavoidable, such as title search and insurance, appraisal and recording fees. However, there are a slew of other fees that many lenders will try to charge, all of which go to their bottom lines. They can include "underwriting fees," "mortgage broker fees," "processing fees," and "application fees." Lenders are required to let you know these costs upfront as part of their Good Faith Estimate, so if they seem unreasonable, either negotiate them down or take your business elsewhere.

THE BOTTOM LINE: Refinancing can be expensive and time-consuming, so make sure you know what you want out of a loan before you start the process.

The Keys to Car Leasing

Question of the week:I'm shopping for a new car and the low monthly payments I'd get by leasing are very attractive. What's your take on leasing a car compared to buying one? --PL

Dear PL,

Those comparatively low monthly payments are exactly what motivate so many people to lease, but you need to look deeper to really understand if leasing or buying is better for your situation. When we asked members of the Armchair Millionaire community about their opinions on buying versus leasing, we got responses in favor of both options. Here are two examples:

"I lease, and I'm very happy with it. We like to get new cars every three or four years, and we don't want to worry about negotiating the trade-in price on the back end, or about costly repairs on an older car. Meanwhile our payments are lower. I have no problem 'renting' a depreciating asset." --Nick

"Buy a good quality car with a reputation for lasting at least 10 years or 200,000 miles and drive it until it won't drive any more. Many folks fret that an older car is always costing them money, in terms of occasional $200 - $500 repairs. But the sad fact is that leasing costs most people that much every month for forever." --Michael B.

In general, leasing might be right for you if:

• For business or personal reasons, you must drive a new or near-new car.
• You drive less than 15,000 miles per year.
• You are able to count lease payments as a business expense.
• You keep your car well maintained and in good condition.
• You're willing to pay more over the long run to avoid the hassles of repairing and selling an older car.

If you decide that you would benefit from leasing your next car, use my checklist to ensure that you get the best deal and minimize extra charges.

The Armchair Millionaire Checklist to Smart Auto Leasing

• Negotiate, negotiate. Just as you should never pay full price when buying a car, you should not agree on a lease that is based on the full sticker price. (In a lease, the "capitalized cost" is the equivalent of the selling price.)

• Look at alternative deals. You don't have to use the dealer's leasing company. Investigate leasing options through independent leasing companies, as well as your bank or credit union, to get the best terms.

• Don't get bushwhacked by fees. Be prepared to pay a range of fees, which can include a security deposit, an acquisition fee (an administration fee charged by the leasing company), a disposition fee (to compensate the leasing company for the expense of selling the car at the end of your lease), sales tax, as well as all the other fees you must pay when you purchase a car, such as registration, license and title fees.

• Make sure the vehicle remains under warranty throughout the lease. If you choose a car with a 36-month warranty, for example, the term of your lease should be no longer than 36 months.

• Be ready to commit to the entire term. If you decide to end the lease earlier than the term specified in your contract, you'll have to pay very high early termination charges.

• Understand "excessive wear and tear." If you turn your car back in at the end of the lease with damage that is greater than "reasonable" (as defined by the leasing company), you'll end up paying a stiff penalty. Know in advance what the leasing company will classify as normal wear, and what it will classify as excessive.

THE BOTTOM LINE: To make a wise decision on whether to buy or lease, look at all associated costs--not just the monthly payment--weigh in your personal circumstances, and then decide if what you get is really worth what you'll pay.

Going Global

Question of the week:You advocate investing one-third of your portfolio in an international mutual fund. The U.S. economy is the biggest and strongest in the world, so why should I bother to invest in foreign countries? --A Skeptic in Seattle Dear Skeptic, You're right that the United States stock market is the largest in the world, but it still only represents about half of the global stock market. If you're investing for the long term, it makes sense to participate in growth all over the world, not just in your own country. We recently asked members of the Armchair Millionaire community about why they invest internationally. Without a doubt, diversification is the most cited reason: "I currently have 20 percent of my portfolio invested in international mutual funds, which I are a great way to increase diversification and decrease risk." --Chris J. "I am a huge fan of international funds as a large part of a diversified portfolio. I feel that one should never limit growth potential to one specific nation." --Vito Z. Like these folks, I believe that any complete diversification plan includes overseas investment. It works because the U.S. and world markets tend to have a low correlation--that is, when one zigs or zags, the other tends not to follow--it's on its own track. It has often been the case that when the U.S. market is in a slump, international markets are up (and vise versa). If you decide to go abroad with a portion of your investments, my quick guide will get you started. The Armchair Millionaire Guide to Investing Internationally How do I do it? Mutual funds are by far the easiest way to invest internationally. Your options include international funds (which invest in countries outside of the U.S.), global funds (which invest all over the world, including the U.S.), regional funds (which specialize in one region, such as Europe or Latin America), and country funds (which invest in just one country). There are also emerging markets funds, which invest in countries with younger, less well-developed economies. How do I choose the right fund? Look at all the things you normally would when choosing a fund, like the fund management, costs, past performance and overall fit with you portfolio. Pay special attention to fees, which tend to be higher in foreign funds than domestic funds, and the experience of the fund manager in that particular part of the world. What about index funds? Like their counterparts here at home, international index funds offer key advantages over actively managed funds: broad diversification, low costs and generally better performance over time. There are a number of international indexes with funds to match, but my favorite is the Morgan Stanley Capital International EAFE index, which tracks blue-chip stocks of Europe, Australia and the Far East. What are the risks? Foreign investments face a couple of special kinds of risks that you should understand. These include currency risk--the chance that fluctuating exchange rates could impact your investment, and country risk--the possibility that economic or political events in a particular country will affect the value of investments. THE BOTTOM LINE: It's a big world out there, and when you're making decisions as important as where to invest for the long term, don't unnecessarily limit your options. Doing so could mean you miss out on both growth and diversification opportunities.