Money 101, Financial Education. Lesson # 9 Controlling Debt

Top things to know

1. Americans are loaded with credit-card debt.
The average American household with at least one credit card has nearly $10,700 in credit-card debt, according to CardWeb.com, and the average interest rate runs in the mid- to high teens at any given time.
2. Some debt is good.
Borrowing for a home or college usually makes good sense. Just make sure you don't borrow more than you can afford to pay back, and shop around for the best rates.
3. Some debt is bad.
Don't use a credit card to pay for things you consume quickly, such as meals and vacations, if you can't afford to pay off your monthly bill in full in a month or two. There's no faster way to fall into debt. Instead, put aside some cash each month for these items so you can pay the bill in full. If there's something you really want, but it's expensive, save for it over a period of weeks or months before charging it so that you can pay the balance when it's due and avoid interest charges.
4. Get a handle on your spending.
Most people spend thousands of dollars without much thought to what they're buying. Write down everything you spend for a month, cut back on things you don't need, and start saving the money left over or use it to reduce your debt more quickly.
5. Pay off your highest-rate debts first.
The key to getting out of debt efficiently is first to pay down the balances of loans or credit cards that charge the most interest while paying at least the minimum due on all your other debt. Once the high-interest debt is paid down, tackle the next highest, and so on.
6. Don't fall into the minimum trap.
If you just pay the minimum due on credit-card bills, you'll barely cover the interest you owe, to say nothing of the principal. It will take you years to pay off your balance, and potentially you'll end up spending thousands of dollars more than the original amount you charged.
7. Watch where you borrow.
It may be convenient to borrow against your home or your 401(k) to pay off debt, but it can be dangerous. You could lose your home or fall short of your investing goals at retirement.
8. Expect the unexpected.
Build a cash cushion worth three months to six months of living expenses in case of an emergency. If you don't have an emergency fund, a broken furnace or damaged car can seriously upset your finances.
9. Don't be so quick to pay down your mortgage.
Don't pour all your cash into paying off a mortgage if you have other debt. Mortgages tend to have lower interest rates than other debt, and you may deduct the interest you pay on the first $1 million of a mortgage loan. (If your mortgage has a high rate and you want to lower your monthly payments, consider refinancing.)
10. Get help as soon as you need it.
If you have more debt than you can manage, get help before your debt breaks your back. There are reputable debt counseling agencies that may be able to consolidate your debt and assist you in better managing your finances. But there are also a lot of disreputable agencies out there.

Good debt vs. bad debt

Sometimes it makes sense to borrow - a lot of times it doesn't.

It's almost impossible to live debt-free; most of us can't pay cash for our homes or our children's college educations. But too many of us let debt get out of hand.
Ideally, experts say, your total monthly long-term debt payments, including your mortgage and credit cards, should not exceed 36 percent of your gross monthly income. That's one metric mortgage bankers consider when assessing the creditworthiness of a potential borrower.
It's far too easy to spend more than you can afford, especially when you pay by credit card. The average U.S. household with at least one credit card carries nearly a $10,700 balance, according to CardWeb.com, and personal bankruptcies have hit record highs in recent years.
Of course, avoiding debt at any cost is not smart either if it means depleting your cash reserves for emergencies. The challenge is learning how to judge which debt makes sense and which does not and then wisely managing the money you do borrow.
Good debt includes anything you need but can't afford to pay for up front without wiping out cash reserves or liquidating all your investments. In cases where debt makes sense, only take loans for which you can afford the monthly payments.
Bad debt includes debt you've taken on for things you don't need and can't afford (that trip to Bora Bora, for instance). The worst form of debt is credit-card debt, since it usually carries the highest interest rates.
Sometimes the decision to borrow doesn't hinge on how much cash you have but on whether there are ways to make your money work harder for you. If interest rates are low, compare what you'll spend in interest on a loan versus what your money could earn if it were invested. If you think you can get a higher return from investing your cash than what you'll pay in interest on a loan, borrowing a small amount at a low rate may make sense.

Three examples of good debt

Home, school and your chariot qualify

Debt is not always a bad thing. In fact, there are instances where the leveraging power of a loan actually helps put you in a better overall financial position.
Buying a home
The chance that you can pay for a new home in cash is slim. Carefully consider how much you can afford to put down and how much loan you can carry. The more you put down, the less you'll owe and the less you'll pay in interest over time.
Although it may seem logical to plunk down every available dime to cut your interest payments, it's not always the best move. You need to consider other issues, such as your need for cash reserves and what your investments are earning.
Also, don't pour all your cash into a home if you have other debt. Mortgages tend to have lower interest rates than other debt, and you may deduct the interest you pay on the first $1 million of a mortgage loan. (If your mortgage has a high rate, you can always refinance later if rates fall. Use our calculator to determine how much you might save.)
A 20 percent down payment is traditional and may help buyers get the best mortgage deals. Many homebuyers do put down less - as little as 3 percent in some cases. But if you do, you'll end up paying higher monthly mortgage bills because you're borrowing more money, and you will have to pay for primary mortgage insurance (PMI), which protects the lender in the event you default.
For more on financing a home, read Money 101: Buying a home.
Paying for college
When it comes to paying for your children's education, allowing your kids to take loans makes far more sense than liquidating or borrowing against your retirement fund. That's because your kids have plenty of financial sources to draw on for college, but no one is going to give you a scholarship for your retirement. What's more, a big 401(k) balance won't count against you if you apply for financial aid since retirement savings are not counted as available assets.
It's also unwise to borrow against your home to cover tuition. If you run into financial difficulties down the road, you risk losing the house.
Your best bet is to save what you can for your kids' educations without compromising your own financial health. Then let your kids borrow what you can't provide, especially if they are eligible for a government-backed Perkins or Stafford loans, which are based on need. Such loans have guaranteed low rates; no interest payments are due until after graduation; and interest paid is tax-deductible under certain circumstances.
For more on educational financing, read Money 101: Saving for College and "Beating the Financial Aid Trap."
Financing a car
Figuring out the best way to finance a car depends on how long you plan to keep it, since a car's value plummets as soon as you drive it off the lot. It also depends on how much cash you have on hand.
If you can pay for the car outright, it makes sense to do so if you plan to keep the car until it dies or for longer than the term of a high-interest car loan or pricey lease. It's also smart to use cash if that money is unlikely to earn more invested than what you would pay in loan interest.
Most people, however, can't afford to put down 100 percent. So the goal is to put down as much as possible without jeopardizing your other financial goals and emergency fund. Typically, you won't be able to get a car loan without putting down at least 10 percent. A loan makes most sense if you want to buy a new car and plan to keep driving it long after your loan payments have stopped.
You may be tempted to use a home equity loan when buying a car because you're likely to get a lower interest rate than you would on an auto loan, and the interest is tax-deductible. But before going this route make sure you can afford the payments. If you default, you could lose your home. And be sure you can pay it off while you still have the car since it's painful to pay for something that has been consigned to the junkyard.
Leasing a car might be your best bet if the following applies: you want a new car every three or four years; you want to avoid a down payment of 10 percent to 20 percent; you don't drive more than the 15,000 miles a year allowed in most leases; and you keep your vehicle in good condition so that you avoid end-of-lease penalties.
Whatever route you choose, shop for the best deals. Remember, it's in the car dealer's best interest to finance at the highest rate possible, so look at what you'll pay overall, not just the monthly amount. If you tell your car dealer you can spend $400 a month, you could end up with a new car for $400 a month based on an uncompetitive interest rate.
For more on auto financing, read Money 101: Buying a car. And to get a sense of how much car you really can afford, click here.

Borrowing for other expenses

A home equity loan or line of credit is smart in some instances.

Besides life's big-ticket items - home, car and college - you may be tempted to borrow money to pay for an assortment of other expenses such as furniture, appliances and home remodeling.
Generally speaking, it's best to pay up front for furniture and appliances since they don't add value to your home and are depreciating assets. If you do finance such purchases, however, read the fine print.
Retail stores often charge high interest rates. And even if they offer a low-interest or no-payment period for several months on a purchase, you may be required to pay for the item in full at the end of that period or risk being charged a high interest rate dating back to the day of sale.
Taking a home equity loan or home equity line of credit makes sense if you're making home improvements that increase the value of your house, such as adding a family room or renovating your kitchen. The interest you pay in many cases is deductible, and you increase your equity.
If, however, a home project doesn't boost your house value, consider paying cash or taking out a short-term, low-interest loan that will be paid off in five years or less.
If you're saddled with a lot of high-interest credit-card debt, you might be tempted to pay it off quickly by borrowing from your 401(k) or taking out a home equity loan.
There are two primary advantages to home equity loans: They typically charge interest rates that are less than half what most credit cards charge. Plus, the interest you pay in most instances is deductible. (Note, however, that when you use a home equity loan for nonhousing expenses, you may only deduct the interest paid on the first $100,000 of the loan, according to the National Association of Tax Practitioners.)
But there is one potential and very significant drawback when you borrow against your house to pay off credit cards: If you default on your home equity loan payments, you may lose your home.
Borrowing from your 401(k) is even less advisable. That's because you lose out on two of the biggest advantages to workplace retirement plans: tax-deferred compounding of your money and tax-deductible contributions. Sure, you pay yourself back with interest, but that interest is paid with after-tax dollars, and it will be harder for you to make new contributions while you're repaying your old loan.
Also, if you quit or lose your job, you'll probably have to repay the entire borrowed amount within three months. If you aren't able to do that, you'll owe income taxes on the money, plus a 10 percent penalty if you're under 59-1/2.
One other word of caution if you take any kind of loan to pay off your credit cards: Once your credit-card debt is paid off, you have to be vigilant about not running up your balance again because you still will have big loan payments to make.
If you're having chronic trouble paying off your credit-card debt, it may be time to consult a debt counseling service for help managing your finances in the future. For assistance in finding a reputable one, click here.

Managing your debt

Simple steps put you - not your bills - in charge.

Outside of fixed monthly bills such as your housing or car payment, you probably don't have a precise idea of how you spend most of your money.
If you want to get your debt under control, start by figuring out your spending patterns and identifying unnecessary expenses.
For one month, write down every cent you spend. "Every" means "every," including that $2 cup of coffee that starts your workday or that $4 magazine you buy on a whim. That will clarify in black and white how much of your spending is fixed and how much is variable (and hence easier to curb).
Tally the expenses on the list and compare the sum to your monthly income.
How much do you bring in after taxes? How much do you have left at the end of the month after paying fixed expenses? How much do you spend on variable items like that $2 cup of coffee every morning?
Consider, too, whether there's any way to boost your take-home pay. If you get a big tax refund every year, that means you're having too much withheld from your paycheck. If that's the case, you can reduce your withholding by changing your W-4 at work.
Next, make a list of all your debt obligations and the interest you're charged for each.
Once you've done all that, you're ready to start lightening your debt load.
The basics of debt reduction are simple: Cut down on your variable spending and put the extra money toward your debt payments. Once you determine the maximum amount you can pay off each month, pay down the debt with the highest interest rate first - that usually means your credit-card balance - while paying at least the minimum monthly amount due on all other revolving bills.
Once the debt with the highest rate is wiped out, put your money toward paying the debt with the next-highest rate. One exception: If you have a credit card with a low teaser rate that will go up after a fixed amount of time, strive to eliminate that balance before the low rate expires.
You might also consider moving some of your high-interest credit-card balances to a card with a lower interest rate. But read the fine print on any invitation to transfer balances. Sometimes such low-interest-rate offers are only in effect for short periods of time, after which the rate skyrockets. What's more, consolidating your debt on one card may lower your credit score if your debt-to-available-credit ratio worsens.
For many people, reining in discretionary spending for a few months goes a long way toward tackling debt. But if that's not enough, try to reduce your fixed expenses. Take steps to lower your household bills; refinance your mortgage to get a lower interest rate; or, if you have a good payment history, ask your credit- card company to lower the interest rate you're charged.
For budget tips, read Money 101: Making a budget.

Get your credit reports and scores

Know what information lenders have on you.

While you're cleaning up your debt, order copies of your credit reports, which are free, and your credit scores, which cost about $15, since the information contained in them will directly affect the interest rates you're offered on credit cards, mortgages and other loans.
There are three major credit bureaus: Experian, Equifax and TransUnion. Each collects information on your credit history which is culled into a credit report. From that report, a credit score is derived. That score is a quick way for lenders to assess how risky you are as a potential borrower. The higher your score, the less risk you pose to lenders and the more likely it is that you'll get their best available rates.
The score most commonly used by lenders is the FICO score, developed by Fair Isaac.
When lenders review your credit reports and resultant FICO scores, they take into account not only how much you owe but also how much credit you have available to you. Too much of either, and they may not loan you any more money.
So when you get your reports, check for inaccuracies; the bureaus are required to investigate and correct them once you report them. Look, too, for things that may lower your credit rating, including open lines of credit you never use or accounts you thought had been closed long ago.
The bureaus may have different information about your credit history, which means your credit score can vary somewhat from bureau to bureau. So it's important to view reports from all three.
You can get any of the bureaus' credit reports free at www.annualcreditreport.com and your FICO score from MyFICO.com. Then check if this is true: If you've been turned down for credit, employment or housing in the past 60 days, you may receive a free credit report from all of the three credit bureaus.

Money 101, Financial Education. Lesson # 8 Buying A Home

Top things to know
1. Don't buy if you can't stay put.
If you can't commit to remaining in one place for at least a few years, then owning is probably not for you, at least not yet. With the transaction costs of buying and selling a home, you may end up losing money if you sell any sooner - even in a rising market. When prices are falling, it's an even worse proposition.
2. Start by shoring up your credit.
Since you most likely will need to get a mortgage to buy a house, you must make sure your credit history is as clean as possible. A few months before you start house hunting, get copies of your credit report. Make sure the facts are correct, and fix any problems you discover.
3. Aim for a home you can really afford.
The rule of thumb is that you can buy housing that runs about two-and-one-half times your annual salary. But you'll do better to use one of many calculators available online to get a better handle on how your income, debts, and expenses affect what you can afford.
4. If you can't put down the usual 20 percent, you may still qualify for a loan.
There are a variety of public and private lenders who, if you qualify, offer low-interest mortgages that require a down payment as small as 3 percent of the purchase price.
5. Buy in a district with good schools.
In most areas, this advice applies even if you don't have school-age children. Reason: When it comes time to sell, you'll learn that strong school districts are a top priority for many home buyers, thus helping to boost property values.
6. Get professional help.
Even though the Internet gives buyers unprecedented access to home listings, most new buyers (and many more experienced ones) are better off using a professional agent. Look for an exclusive buyer agent, if possible, who will have your interests at heart and can help you with strategies during the bidding process.
7. Choose carefully between points and rate.
When picking a mortgage, you usually have the option of paying additional points -- a portion of the interest that you pay at closing -- in exchange for a lower interest rate. If you stay in the house for a long time -- say three to five years or more -- it's usually a better deal to take the points. The lower interest rate will save you more in the long run.
8. Before house hunting, get pre-approved.
Getting pre-approved will you save yourself the grief of looking at houses you can't afford and put you in a better position to make a serious offer when you do find the right house. Not to be confused with pre-qualification, which is based on a cursory review of your finances, pre-approval from a lender is based on your actual income, debt and credit history.
9. Do your homework before bidding.
Your opening bid should be based on the sales trend of similar homes in the neighborhood. So before making it, consider sales of similar homes in the last three months. If homes have recently sold at 5 percent less than the asking price, you should make a bid that's about eight to 10 percent lower than what the seller is asking.
10. Hire a home inspector.
Sure, your lender will require a home appraisal anyway. But that's just the bank's way of determining whether the house is worth the price you've agreed to pay. Separately, you should hire your own home inspector, preferably an engineer with experience in doing home surveys in the area where you are buying. His or her job will be to point out potential problems that could require costly repairs down the road.

Are you ready to own?
Home ownership means you no longer pay monthly rent for the roof over your head. You can do what you want with your house (within reason). When you leave, you can sell it to recoup the purchase price and - with any luck - earn a profit too.
But don't kid yourself. Home ownership comes with a slew of disadvantages, responsibilities, and downright headaches.
So before going any further, consider whether your lifestyle and finances make home buying a smart move.
TIP: High costs mean you should be prepared to stay put. Except in a roaring real estate market, it usually doesn't make sense to buy a home you'll own for less than three or four years. Reason: the high transaction cost of buying and selling property means you could lose money on the deal. If you do make money, you'll pay capital gains taxes if you're in the house less than two years.
When home prices are falling, it just makes the case against buying even stronger. So ask yourself if you can really stay put for that long. Will you need to move because you are transferred by your current employer or a new one? Are you thinking of going back to school?
TIP: It may make more sense to rent On the financial side, one key question is whether it costs more, on average, to rent or own in your area. The rule of thumb is that if you pay 35 percent less in rent than you would for owning - including the monthly mortgage, property taxes, and any homeowner's fees - then it's smarter to continue renting.
Only if all those answers still point towards owning should you proceed to the next step - getting the money right.

Getting the money right
For most people, buying a house involves a double financial whammy.
First you have to assemble a pile of cash for the down payment and closing costs. Then you must convince a bank to lend you an even more staggering sum - generally 80 percent or more of the purchase price.
So your first step, even before you start the actual hunt for a property, should be to get your financial house in order.
Start with your credit
Credit reports are kept by the three major credit agencies, Experian, Equifax, and TransUnion. Among other things, they show whether you are habitually late with payments and whether you have run into serious credit problems in the past.
A credit score is a number calculated from a formula created by Fair Isaac based on the information in your credit report. You have three different credit scores, one for each of your credit reports.
A low credit score may hurt your chances for getting the best interest rate, or getting financing at all. So get a copy of your reports and know your credit scores. Try Fair Isaac's MyFICO.com, which charges $15.95 each for reports and scores from Equifax and TransUnion. Experian scores and reports can be accessed from experian.com and cost $15.
Errors are not uncommon. If you find any, you must contact the agencies directly to correct them, which can take two or three months to resolve. If the report is accurate but shows past problems, be prepared to explain them to a loan officer.
Know what you can afford
Next, you need to determine how much house you can afford. You can start with one of the Web's many calculators. For a more accurate figure, ask to be pre-approved by a lender, who will look at your income, debt and credit to determine the kind of loan that's in your league.
The rule of thumb here is to aim for a home that costs about two-and-a-half times your gross annual salary. If you have significant credit card debt or other financial obligations like alimony or even an expensive hobby, then you may need to set your sights lower.
Another rule of thumb: All your monthly home payments should not exceed 36 percent of your gross monthly income.
The size of your down payment will also determine how much you can afford.
Line up cash
If you haven't already, you'll need to come up with cash for your down payment and closing costs. Lenders like to see 20 percent of the home's price as a down payment. If you can put down more than that, the lender may be willing to approve a larger loan. If you have less, you'll need to find loans that can accommodate you.
Various private and public agencies - including Fannie Mae, Freddie Mac, the Federal Housing Administration, and the Department of Veterans Affairs - provide low down payment mortgages through banks and mortgage companies. If you qualify, it's possible to pay as little as 3 percent up front. For more, check out their Web sites at Fanniemae.com or Freddiemac.com.
A warning: With a down payment under 20 percent, you will probably wind up having to pay for private mortgage insurance, a safety net protecting the bank in case you fail to make payments. PMI adds about 0.5 percent of the total loan amount to your mortgage payments for the year. So if you finance $200,000, your PMI will cost $1,000 annually.
Once you've considered the down payment, make sure you've got enough to cover fees and closing costs. These may include the appraisal fee, loan fees, attorney's fees, inspection fees, and the cost of a title search. They can easily add up to more than $10,000 - and often run to 5 percent of the mortgage amount.
If your available cash doesn't cover your needs, you have several options. First-time homebuyers can withdraw up to $10,000 without penalty from an Individual Retirement Account, if you have one, though you must pay taxes on the amount. You can also receive a cash gift of up to $13,000 a year (the limit for 2009) from each of your parents without triggering a gift tax.
Gift taxes are paid by the donor, not the recipient. (In fact, if your and your spouse's parents are both well-heeled, they can give you a total of $104,000 in one year - $13,000 from each of the four parents to each of you.)
Check on whether your employer can help; some big companies will chip in on the down payment or help you get a low-interest loan from selected lenders. You can also tap a 401(k) or similar retirement plan for a loan from yourself.

Picking a team
Don't buy a home without professional help.

With all the tools and advice available today ranging from books and magazines to online advice like this lesson - it would be possible for you to buy your home almost completely without the aid of real estate professionals.
That's not necessarily recommended. The housing market, like politics, is basically local, and each state, city, and even neighborhood has a thicket of local laws or customs that you need to understand. For that, it helps to have a team of professionals to guide you.
You might want to start by finding an agent who can represent your interests in the search. This is not as simple as it sounds. Sure, 85 percent of sellers list their homes through an agent - but those agents are working for the seller, not you. They're paid based on a percentage, usually 5 to 7 percent of the purchase price, so their interest will be in getting you to pay more.
What you need is what's known as an "exclusive buyer agent." Sometimes buyer agents are paid directly by you, on an hourly or contracted fee. Other times they split the commission that the seller's agent gets upon sale. A buyer's representative has the same access to homes for sale that a seller's agent does, but his or her allegiance is supposed to be only to you.
To complicate matters, there are hybrid agencies called either single-agency or dual-agency brokers. In both cases, an individual agent in the firm may represent either sellers or buyers, sometimes both, in the same transaction. Potential conflicts of interest abound in this situation, so if you are seeking a buyer agent but no exclusive buyer agent is available, make sure to ask the agent about conflicts of interest.
There are now about a dozen Web sites that help connect buyers with buyers agents, among them HomeGain.com, House.com, RealEstate.com and Reply.com.
Next start looking for a mortgage lender. Take your time, since you could be paying this loan for 30, even 40, years. Start on the Internet at places like LendingTree.com and E-loan.com. You may also want to check out the rates at CNNMoney.com, Bankrate.com, or HSH Associates. These sites carry nationwide listings of mortgage interest rates and other related information.
Don't limit your search to the Web, though. Once you have an idea of the best rates from national lenders, get on the phone to your community banks and any other institutions with which you may have a relationship. Ask if they can beat the national rates. Often, the local lender can offer a better deal simply because he or she knows the local market and wants to keep your business.
You might also consider using a mortgage broker, a middleman who keeps tabs on rates from a multitude of lenders. The mortgage broker isn't paid directly by you but gets paid by the bank. However, the fee - usually 1.5 to 3 percent of the loan amount - may get transferred to you in the closing costs. Most search engines have extensive listings of mortgage brokers. There's also a trade group, the National Association of Mortgage Brokers, which can put you in touch with a broker in your area.

The hunt
Now it's time to hit the pavement, or the Web, in search of a home
Your first step here is to figure out what city or neighborhood you want to live in. (Remember the old saw about "location, location, location.")
For overall demographics and data on metropolitan areas, you can visit a city site like CNNMoney.com's annual Best Places to Live list. For more detailed neighborhood information, check out sites like Yahoo! Real Estate, Trulia.com, Zillow.com or NeighborhoodScout for comprehensive school and demographic information on a number of communities. Look for signs of economic vitality: a mixture of young families and older couples, low unemployment and good incomes.
Pay special attention to districts with good schools (high teacher-student ratios and graduation rates are among the hallmarks), even if you don't have school-age children. When it comes time to sell, you'll find that a strong school system is a major advantage in helping your home retain or gain value.
Try also to get an idea about the real estate market in the area. For example, if homes are selling close to or even above the asking price, that shows the area is desirable. Try Homegain.com, which is free, or Dataquick.com, which is available only to paid subscribers, to check out recent home sales.
Your real estate agent may also be able to show you listings. Incidentally, if you have the flexibility, consider doing your house hunt in the off-season -- meaning, generally, the colder months of the year. You'll have less competition and sellers may be more willing to negotiate.
Next, take your search to real estate sites like Realtor.com or Yahoo Real Estate, which let you search for property that fit your requirements.
Be wary of choosing search criteria that are too restrictive. For example, select a price range 10 percent above and 10 percent below your true range. Add a 10-mile cushion to the location you specify. If you see a house you are interested in, save it, print it, add it to your bookmark or favorites list, and take note of the MLS code; your agent will want that code to arrange to show you the home in person.
If you're a first-time buyer, pay special attention to condominiums and cooperatives, or co-ops. Condos generally sell for 15 percent to 20 percent less than the cost of comparable detached homes in the same neighborhood, so you get much more space for your money.
What's the difference between the two? In a condo, each owner has absolute ownership of his own unit, which may be an apartment or townhouse. Owners pay a monthly fee to maintain shared areas like the lobby, the pool, or the laundry room. The chief financial risk to a condo owner is that the common charges can rise, or, in the event of a major problem such as a roof repair or boiler replacement, the condo board can assess fees to cover expensive repairs.
It's a good idea, when considering a condo, to find out how much the common charge has changed over the past five years, and whether there have been major assessments during that time. Also ask what percentage of the residents actually own their units as opposed to just renting them (many condos include both). A complex with lots of renters has fewer owners who care about the upkeep, and it may be harder to get a loan on such a property.
A co-op is a rarer animal limited to major metropolitan areas, especially New York City. Essentially, the complex is run by a corporation where each owner is a shareholder. In other words, a co-op owner is a partner in a building, rather than an outright owner of his or her specific unit within that building.
The monthly maintenance fees are generally higher than those of a condo because they include property taxes (condo owners pay their own separately, but prices tend to be lower. Their chief downside is that the co-op board usually has to approve new owners and may discourage you from renting your unit if you move out without selling. As with a condo, check on the group's financial health, whether shareholders have been hit with special assessments recently, and whether the unit includes many renters.
When you actually start touring homes, bring a notebook and a digital camera to help you remember details. Your real estate agent should supply you with a description of each house and the lot it sits on, the property tax assessment, the asking price, and sometimes a diagram of the rooms. Your camera and notebook are there to record other details, ranging from the cost of heating to the view out the rear window.
One note: Don't automatically reject a house just because it doesn't measure up to your desires, either in features or price. You can always add a deck, for instance, or update a kitchen. Since the asking price is just a starting point for negotiation, you will be making offers and counteroffers as both parties seek an acceptable price.

Closing the deal
Here's where you exercise your haggling muscles.
Once you find the house you want, you need to move quickly to make your bid. If you're working with a buyer's broker, then get advice from him or her on an initial offer. If you're working with a seller's agent, devise the strategy yourself.
Try to line up data on at least three houses that have sold recently in the neighborhood. Calculate the difference between the original list price and the final price of the homes sold.
If the average difference is, say, 5 percent below the asking price, then you know you can make an offer 8 percent to 10 percent below, leaving yourself a little room to negotiate. If you really want the house, don't lowball. The seller may give up in disgust.
Another factor to consider in determining your bid is whether the trend in recent home sales is up or down over the past year. For instance, if houses a year ago were selling at list, and recent ones are going at 3 percent below, then you might want to sharpen your pencil for your opening bid to just 5 to 8 percent below list.
There's no foolproof system for negotiating a fair price. Occasionally it's best to deal directly with the seller yourself. More often it's better to work exclusively through intermediaries. In general, don't let the other side begin to believe you are negotiating in bad faith or being deceptive -- any deal you eventually reach has to involve trust on both sides.
Be creative about finding ways to satisfy the seller's needs. For instance, ask if the seller would throw in kitchen and laundry appliances if you meet his price -- or take them away in exchange for a lower price. Remember, too, that your leverage depends on the pace of the market. In a slow market, you've got muscle; in a hot market, you may have none at all.
Once you reach a mutually acceptable price, the seller's agent will draw up an offer to purchase that includes an estimated closing date (usually 45 to 60 days from acceptance of the offer).
Have your lawyer or buyers agent review this document to make sure the deal is contingent upon:
1. your obtaining a mortgage;
2. a home inspection that shows no significant defects (make sure you're clear on the definition of "significant");
3. a guarantee that you may conduct a walk-through inspection 24 hours before closing. This last clause allows you to check the home after the sellers have moved out so that you have time to negotiate payment for repairs, just in case the movers cause any damage, or that big living room sofa was hiding a hole in the floor.
You also need to make a good-faith deposit -- usually 1 percent to 10 percent of the purchase price -- that should be deposited into an escrow account. The seller will receive this money after the deal has closed. If the deal falls through, you will get the money back only if you or the home failed any of the contingency clauses.
Now call your mortgage broker or lender and move quickly to agree on terms, if you have not already done so. This is when you decide whether to go with the fixed rate or adjustable rate mortgage and whether to pay points (see "Picking a team"). Expect to pay $50 to $75 for a credit check at this point, and another $150, on average to $300 for an appraisal of the home. Most other fees will be due at the closing.
If you don't already have one, look into taking out a homeowner's insurance policy, too. Ask for recommendations from friends, your lawyer or your real estate agent. Most lenders require that you have homeowner's insurance in place before they'll approve your loan.
In addition to the appraisal that the mortgage lender will make of your home, you should hire your own home inspector. Again, ask for referrals, or check with the American Society of Home Inspectors, a trade group. An inspection costs about $300, on average, and up to $1,000 for a big job and takes two hours or more.
Ask to be present during the inspection, because you will learn a lot about your house, including its overall condition, construction materials, wiring, and heating. If the inspector turns up major problems, like a roof that needs to be replaced, then ask your lawyer or agent to discuss it with the seller. You will either want the seller to fix the problem before you move in, or deduct the cost of the repair from the final price. If the seller won't agree to either remedy you may decide to walk away from the deal, which you can do without penalty if you have that contingency written into the contract.
About two days before the actual closing, you will receive a final HUD Settlement Statement from your lender that lists all the charges you can expect to pay at closing.
Review it carefully. It will include things like the cost of title insurance that protects you and the lender from any claims someone may make regarding ownership of your property. The cost of title insurance varies greatly from state to state but usually comes in at less than 1 percent (in Iowa, as little as 0.1 percent plus a fixed fee) of the home's price.
The lender might also require you to establish an escrow account, which it can tap if you fall behind on your mortgage or property tax payments. Lenders can require deposits of up to two months' worth of payments.
After all this rigmarole, the actual closing is often somewhat anticlimactic, though perhaps still nerve-racking. It's a ritual affair, with customs that differ by region. Your lawyer or real estate agent can brief you on the particulars.

For sellers only
Preparation and timing can help you get the best price.
When you decide to sell, the first thing to do is investigate the local housing market.
Consult the large real estate sites, like Realtor.com, Zillow.com and HomeGain.com to see how similar homes are priced in your neighborhood. Many newspapers also list the selling and asking prices of recent sales, plus how long the houses were on the market. Note the prices for your neighborhood during the last several months.
Check how sales were running, say, a year ago, so you get an idea of whether the market is heating up, cooling down, or staying put. This exercise should give you a sense of what your home is worth.
Selecting an agent
You may decide that you can sell your home without an agent. It's an attractive thought, since you would save the 6 percent of the selling price that a broker typically collects. But balance that against the work involved in advertising a house and being available at all hours to show it.
If you do decide to work through an agent, ask for referrals from friends or check the Web and local newspapers for advertisements. Don't simply accept any recommendation. Make an appointment with an agent and interview him or her for the job.
Evaluate the person as though you were a buyer: Is he or she professional and personable? Does he say the right things to make you want to see the home? Also, since the agent will likely be able to advise you on a selling price, how well does his or her price jibe with the homework you did on your own? Don't be fooled by an agent who is merely flattering you with an inflated price. Go by what you already know about your house and the current housing market.
Ask whether he or she will be the agent actually showing the house. Some brokers have specialists whose main duty is to win the listing. Then another of the broker's agents takes over.
The lowdown on commissions
Once you find an agent you like, you have to formally sign a listing agreement. This is a contract, laying out the specifics of your arrangement, including how long you will let the agent represent your home and what the compensation will be.
Many agents prefer an exclusive listing, meaning you agree to pay a commission regardless of whether the agent is actually responsible for finding the seller. You should commit for no longer than three months (one month, in a hot market). In case you find the agent lacking in enthusiasm, you don't want to be locked into a bad situation.
When you discuss the listing agreement, discuss other issues as well. For instance, if there are certain times when you want the house off-limits for walk-throughs, let the agent know.
Also, consider negotiating the commission. If your house is expensive, an agent might not flinch if you suggest 4 or 5 percent instead of the usual 6. Conversely, if you know it's a buyer's market, consider offering the incentive of a higher commission if the agent can land you a sale within 5 percent of your asking price.
After you've signed a listing agreement, you may want to give your lawyer a call to notify him or her that you're selling your house and will need help reviewing bids and contracts. If you don't want to pay for a lawyer, your agent should also be able to guide you through this process.
Getting ready for an open house
Whether you sell on your own or work with an agent, you'll want to spruce up your house before it goes on the market.
Take an objective look at it: Is it cluttered? A little worn and tired? Consider a new paint job. Tidy up. Move unneeded furniture into the attic, basement or rented storage. Remove some of your personal items, like family pictures and knickknacks. Mow the lawn. Plant flowers, if it's the right season. These seemingly insignificant details can add many thousands of dollars to your eventual sales price.
If you're no good at this kind of thing, consider hiring a home "stager," someone with experience preparing homes for showings. Their fees can be more than offset by quicker sales and higher selling prices.
Speaking of which, you'll need to settle on an asking price. In doing so, forget what you originally paid for the house, how much you've spent on renovations or remodeling, and even how much money you need to move on to your next home. When it comes to pricing your property, the only yardstick that matters is what comparable homes are selling for in your neighborhood now -- which may be more, or less, than you sank into it.
Your research will already have given you a good idea of how the market is faring. Your agent should also provide you with comparable sales and discuss why your house should be priced higher or lower.
Timing is the key
Also note how long the homes were on the market. If you're in a seller's market, with listings moving in a week or two, think about adding a premium to the asking price.
In a buyer's market, it's especially important to get the price right. The critical selling time is within the first month after your home hits the market. If the price is too high, you'll turn off potential buyers and agents and then have a hard time attracting them back, even if you lower your sights later.
When you receive a bid via your agent ask for guidance in how to respond. This will depend on how you priced the house, what the housing market is in your area and your urgency to sell or wait for a better price.
Make sure your lawyer or agent reviews the contingency clauses included with the bid. For example, it's generally not a good idea to agree to sell your home with the contingency that the buyer must first sell his or her own home.
Also make sure that all the buyer's contingencies are restricted within specific amounts of time. For instance, if the deal is contingent upon the home passing an inspection, then the inspection must occur within a week to 10 days of an accepted bid. The same is true of the closing date: Make the buyer commit to a reasonable date, usually 45 to 60 days from acceptance.

Money 101, Financial Education. Lesson # 7 Investing in Bonds

Top things to know
1. Bonds are fancy IOUs
Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it General Electric or Uncle Sam. In return, bond holders get back the loan amount plus interest payments.
2. Stocks do not always outperform bonds.
It is only in the post-World War II era that stocks so widely outpaced bonds in the total-return derby. Stock and bond returns were about even from about 1870 to 1940. And, of course, bonds were well in front in 2000, 2001 and 2002 before stocks once again took charge in 2003 and 2004. By 2008, however, the bond market had far outpaced the stock market once again.
3. You can lose money in bonds.
Bonds are not turbo-charged CDs. Though their life span and interest payments are fixed -- thus the term "fixed-income" investments -- their returns are not.
4. Bond prices move in the opposite direction of interest rates.
When interest rates fall, bond prices rise, and vice versa. If you hold a bond to maturity, price fluctuations don't matter. You will get back the original face value of the bond, along with all the interest you expect.
5. A bond and a bond mutual fund are totally different animals.
With a bond, you always get your interest and principal at maturity, assuming the issuer doesn't go belly up. With a bond fund, your return is uncertain because the fund's value fluctuates.
6. Don't invest all your retirement money in bonds.
Inflation erodes the value of bonds' fixed interest payments. Stock returns, by contrast, stand a better chance of outpacing inflation. Despite the drubbing stocks sometimes take, young and middle-aged people should put a large chunk of their money in stocks. Even retirees should own some stocks, given that people are living longer than they used to.
7. Consider tax-free bonds.
Tax-exempt municipal bonds yield less than taxable bonds, but they can still be the better choice for taxable accounts. That's because tax-frees sometimes net you more income than you'd get from taxable bonds after taxes, provided you're in the 28 percent federal tax bracket or higher.
8. Pay attention to total return, not just yield.
Returns are a slippery matter in the bond world. A broker may sell you a bond that is paying a "coupon" - or interest rate - of 6 percent. If interest rates rise, however, and the price of the bond falls by, say, 2 percent, its total return for the first year - 6 percent in income less a 2 percent capital loss - would be only 4 percent.
9. If you want capital gains, go long.
When interest rates are high, gamblers who want to bet that they'll head lower should buy long-term bonds or bond funds, especially "zeros." Reason: when rates fall, longer-term bonds gain more in price than shorter-term bonds. So you win big - scoring a large potential capital gain in addition to whatever interest the bond may be paying. If rates rise, on the other hand, you lose big, too.
10. If you want steady income, stick with short to medium terms.
Investors looking for income should invest in a laddered portfolio of short- and intermediate-term bonds. For more on laddered portfolios, see our "Sizing up risks."

Why bonds?
Think "bonds," and you probably think "safe," "reliable," and . . . "boring." But that is only half the story.
Bonds can provide a worry-free stream of income. But this class of securities, which crushed stocks during the three-year bear market of 2000 through 2002, also includes a wide array of instruments with varying degrees of risk and reward.
Used improperly, bonds can really mess up your financial life. Handled with care, however, bonds are among the most valuable tools in your investment kit. Here are some of the benefits they can provide:
- Diversification. Large company stocks have posted compound annual returns of around 9.6% percent since 1926, versus 5.7% for long-term U.S. government bonds, according to Ibbotson Associates. Yet while stocks have returned more than bonds, they are also more volatile. Combining stocks with bonds will net you a more stable portfolio. As seen during the bear market, bonds' positive returns offset the double-digit losses from stocks.
- Income. Because bonds pay interest regularly, they are a good choice for investors -- such as retirees -- who desire a steady stream of income.
- Security. Next to cash, U.S. Treasurys are the safest, most liquid investments on the planet. Short-term bonds are a good place to park an emergency fund or money you'll need relatively soon - say to buy a house or send a child to college.
- Tax savings. Certain bonds provide tax-free income. Although these bonds usually pay lower yields than comparable taxable bonds, investors in high tax brackets (generally, 28 percent and above) can often earn higher after-tax returns from tax-free bonds.

How bonds work
The ins and outs of taxable and tax-free debt
Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it General Electric or Uncle Sam.
In exchange, the borrower promises to pay you interest every year and to return your principal at "maturity," when the loan comes due, or at "call" if the bond is of the type that can be called earlier than its maturity (more on this later). The length of time to maturity is called the "term."
A bond's face value, or price at issue, is known as its "par value." Its interest payment is known as its "coupon."
A $1,000 bond paying 7 percent a year has a $70 coupon (actually, the money would usually arrive in two $35 payments spaced six months apart). Expressed another way, its "coupon rate" is 7 percent. If you buy the bond for $1,000 and hold it to maturity, the "yield," or actual earnings on your investment, is also 7 percent (coupon rate divided by price = yield).
The prices of bonds fluctuate throughout the trading day as, of course, do their yields. But the coupon payments stay the same.
Say you don't buy the bond right at the offering, and instead buy from somebody else in the "secondary" market. If you buy the bond for $1,100 in the secondary market, though, the coupon will still be $70, but the yield is 6.4 percent because you paid a "premium" for the bond.
For a similar reason, if you buy it for $900, its yield will be 7.8 percent because you bought the bond at a "discount." If its current price equals its face value, the bond is said to be selling at "par."
The bottom line: There are many ways of expressing a bond's return, but "total return" is the only one that really matters. This includes all the money you earn off the bond: the annual interest and the gain or loss in market value, if any.
If you sell that $1,000 bond with the $70 coupon for $1,050 after one year, your total return is $120, or 12 percent -- $70 in interest and $50 in capital gains. (Prices are usually expressed based on a par value of 100, so when you sell that bond for $1,050 the price would be quoted as 105.)

Types of bonds
U.S. Treasurys are the safest bonds of all because the interest and principal payments are guaranteed by the "full faith and credit" of the U.S. government. Interest is exempt from state and local taxes, but not from federal tax. Because of their almost total lack of default risk, Treasurys carry some of the lowest yields around.
Treasurys come in several flavors:
- Treasury bills, or "T-bills," have the shortest maturities - 13 weeks, 26 weeks, and one year. You buy them at a discount to their $10,000 face value and receive the full $10,000 at maturity. The difference reflects the interest you earn.
- Treasury notes mature in two to 10 years. Interest is paid semiannually at a fixed rate. Minimum investment: $1,000 or $5,000, depending on maturity.
- Treasury bonds have the longest maturities at 10 years. As with Treasury notes, they pay interest semiannually, and are sold in denominations of $1,000.
- Zero-coupon bonds, also known as "strips" or "zeros," are Treasury-based securities that are sold by brokers at a deep discount and redeemed at full face value when they mature in six months to 30 years. Although you don't actually receive your interest until the bond matures, you must pay taxes each year on the "phantom interest" that you earn (it's based on the bond's market value, which usually rises steadily during the time you hold it). For that reason, they are best held in tax-deferred accounts. Because they pay no coupon, zeros can be highly volatile in price.
- Inflation-indexed Treasurys. These pay a real rate of interest on a principal amount that rises or falls with the consumer price index. You don't collect the inflation adjustment to your principal until the bond matures or you sell it, but you owe federal income tax on that phantom amount each year - in addition to tax on the interest you receive currently. Like zeros, inflation bonds are best held in tax-deferred accounts.
- Mortgage-backed securities represent an ownership stake in a package of mortgage loans issued or guaranteed by government agencies such as the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corp. (Freddie Mac), and Federal National Mortgage Association (Fannie Mae). Interest is taxable and is paid monthly, along with a partial repayment of principal. Ginnie Mae has always been backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac, on the other hand, have been under government control since Sept. 2008, putting Uncle Sam on the hook to guarantee their mortgage-backed securities. The volatile mortgage market in late 2007 taught investors that risks for these kinds of bonds are by no means negligible. Mortgage-backed securities generally yield between 2% and 4% more than Treasurys of comparable maturities. Minimum investment: typically $25,000.
- Corporate bonds pay taxable interest. Most are issued in denominations of $1,000 and have terms of one to 20 years, though maturities can range from a few weeks to 100 years. Because their value depends on the creditworthiness of the company offering them, corporates carry higher risks and, therefore, higher yields than super-safe Treasurys. Top-quality corporates are known as "investment-grade" bonds. Corporates with lower credit quality are called "high-yield," or "junk," bonds. Junk bonds typically pay higher yields than other corporates.
- Municipal bonds, or "munis," are one of America's favorite tax shelters. They are issued by state and local governments and agencies, usually in denominations of $5,000 and up, and mature in one to 30 or 40 years. Interest is exempt from federal taxes and, if you live in the state issuing the bond, state and possibly local taxes as well. (Note that there are exceptions). The capital gain you may make if you sell a bond for more than it cost you to buy it is just as taxable as any other gain; the tax-exemption applies only to your bond's interest.
Munis generally offer lower yields than taxable bonds of similar duration and quality. Because of their tax advantages, though, their after-tax returns are often higher than equivalent taxable bonds for people in the 28 percent federal tax bracket or above.
To compare taxable and tax-free yields, use our tax-equivalent yield converter - which is the next step in this lesson.

Tax-equivalent yield converter
Check this link: http://money.cnn.com/magazines/moneymag/money101/lesson7/index5.htm

Sizing up risk
So you think bonds are totally safe and predictable?
Many people believe they can't lose money in bonds. Wrong! Although the interest payments you'll get from owning a bond are "fixed," your return is anything but.
Here are the major risks that can affect your bond's return:
Inflation risk
Since bond interest payments are fixed, their value can be eroded by inflation. The longer the term of the bond, the higher the inflation risk. On the other hand, bonds are a classic deflation hedge; deflation increases the value of the dollars that bond investors get paid.
Interest rate risk
Bond prices move in the opposite direction of interest rates. When rates rise, bond prices fall because new bonds are issued that pay higher coupons, making the older, lower-yielding bonds less attractive. Conversely, bond prices rise when interest rates fall because the higher payouts on the old bonds look more attractive relative to the lower rates offered on newer ones.
The longer the term of the bond, the greater the price fluctuation - or volatility - that results from any change in interest rates.
There is a close connection between inflation risk and interest rate risk since interest rates tend to rise along with inflation. Interest rate shifts are also a concern for mortgage-backed bondholders, but for a different reason: If interest rates fall, home owners may decide to prepay their existing mortgages and take out new ones at the lower rates.
That doesn't mean you'll lose your principal if you hold such a bond. But it does mean you get your principal back much sooner than expected, forcing you to reinvest it at the newly lower rates. For that reason, the prices of mortgage-backed securities don't get as big a boost from falling rates as other kinds of bonds.
Note that price fluctuations only matter if you intend to sell a bond before maturity, or you invest in a bond fund whose manager trades regularly. If you hold a bond to its maturity, you will be repaid the bond's full face value.
But what if interest rates fall and the issuer of your bond wants to lower its interest costs? This brings us to the next type of risk . . .
Call risk
Many corporate and muni bond issuers reserve the right to redeem, or "call," their bonds before they mature, at which point the issuer is required to pay bondholders only par value. Typically, this happens if interest rates fall and the issuer sees it can lower its costs by selling new bonds with lower yields.
If you happen to own one of the called bonds, not only do you get less than the market price of the bond, but you also have to find a place to reinvest the money. Because of the risk that you won't get the income you expect, callable bonds usually pay a higher rate of interest than comparable, noncallable bonds. So, when you buy bonds, make sure to ask not only about the time to maturity, but also about the time to a likely call.
Credit risk
This is the risk that your bond issuer will be unable to make its payments on time - or at all - and it depends on the type of bond you own and the borrower's financial health. U.S. Treasurys are considered to have virtually no credit risk, junk bonds the highest.
Bond rating agencies such as Standard & Poor's and Moody's evaluate corporations and municipalities for their credit worthiness. Bonds from the strongest issuers are rated triple-A. Junk bonds are rated Ba and lower from Moody's, or BB and lower from S&P. (You can check out a bond's rating for free by calling S&P at 212-438-2400 or Moody's at 212-553-0377, or by checking some of the bond websites we identify in "Buying bonds.")
The highest-quality municipal bonds are backed by bond insurance companies, but there is a trade-off: Insured munis typically yield up to 0.3 percentage points less than comparable uninsured munis. Further, the insurance only guarantees your interest and principal; it won't shield you against interest rate or market risk.
Some higher-coupon munis are also "pre-refunded," meaning that, for esoteric reasons, they are effectively backed by U.S. Treasurys. When a muni is pre-refunded by an issuer, its credit quality and price rise.
Liquidity risk
In general, bonds aren't nearly as liquid as stocks because investors tend to buy and hold bonds rather than trade them. While there is always a ready market for super-safe Treasurys, the markets for other bonds, especially munis and junk bonds, can be highly illiquid. If you are forced to unload a thinly-traded bond, you will probably get a low price.
Market risk
As with most other investments, bonds follow the laws of supply and demand. The more popular or less plentiful a bond, the higher the price it commands in the market. During economic meltdowns in Asia and Russia, for example, the price of safe-haven U.S. Treasurys rose dramatically.
You can't eliminate these risks altogether. Now that you understand them, you may be able to reduce their impact by some of the methods described in the next section of this lesson.

Buying bonds
How and where to invest wisely
If you've stuck with the lesson to this point, you are probably interested in knowing more about how to purchase bonds. Here are the main ways:
Directly from the Feds
U.S. Treasurys are sold by the federal government at regularly scheduled auctions. You can buy them through a bank or broker for a fee, but why pay for something you can get for nothing? The easiest and cheapest way to participate in this market is to buy them directly from the Treasury. You can check out the Treasury Direct program on the Web or by calling 800-722-2678. You also can sell bonds you already own before maturity through the Treasury's newer Sell Direct program.
Through a broker
With the exception of Treasurys, buying individual bonds isn't for the faint of heart. Most new bonds are issued through an investment bank, or "underwriter," rather than directly to the public. The issuer swallows the sales commission, so you get the same price big investors pay.
That's why, when buying individual bonds, you should buy new issues directly from the underwriter whenever possible - since you're getting them at wholesale.
Older bonds are another matter. They are traded through brokers on the "secondary market," usually over the counter rather than on an exchange, such as the New York Stock Exchange. Here, transaction costs can be much higher than with stocks because spreads - the difference between what a dealer paid for a bond and what he'll sell it for - tend to be wider.
You will seldom know what spread you paid, unfortunately, because the markup is set by the dealer and built into the price of the bond. There is no fixed commission schedule. One ray of sunshine: In early 2002 the Bond Market Association began posting some muni bond prices on its Web site. Alas, the prices include dealer markups because dealers protested listing commissions separately.
If you do plan to invest in individual bonds, you should probably have enough money to invest - say $25,000 to $50,000 at a minimum - to achieve some degree of diversification, as we'll explain below. (If you have less, consider bond funds, also described below.)
Exactly how you invest depends largely on your objective:
- If your objective is to achieve capital gains, concentrate on long-term issues. Reason: as noted in "Sizing up risks," the longer the term of a bond, the more pronounced are its price swings when interest rates move. That works to your advantage if interest rates fall. Your long-term bonds - especially zero-coupon bonds - will suddenly be worth a lot more. Of course, it works to your distinct disadvantage if interest rates rise; your portfolio drops in value. This kind of bond investing is essentially a bet that interest rates will fall, and its subject to all the same risks - including that of substantial losses - as any other market-timing strategy.
- If your objective is a steady, secure stream of income, adopt a more conservative approach. Specifically:
Stick to shorter terms. Bonds with maturities of one to 10 years are sufficient for most long-term investors. They yield more than shorter-term bonds, and are less volatile than longer-term issues.
Spread your money around. Invest in a variety of bonds with different maturities, either by buying a bond fund or buying a half-dozen or more individual bonds.
Build a laddered portfolio. Each rung of your ladder consists of a different maturity bond, from one year right on up to 10 years. When the one-year bond matures, you reinvest the money in a new, 10-year issue. In this way, you always have more money to reinvest every year, and you are somewhat protected from interest rate shifts because you have locked in a range of yields.
Through a mutual fund
It can make sense to buy individual bonds if you own a lot of them and hold them to maturity, but most people are better off buying bonds through mutual funds. The biggest reason is diversification. Because bonds are sold in large units, you might only be able to purchase one or a handful of bonds on your own, but as a bond fund holder you'll own stakes in dozens, perhaps hundreds, of bonds.
You will also get the benefit of professional research and money management. Another advantage: Dividends are paid monthly, versus only semiannually for individual bonds, and can be reinvested automatically. Lastly, bond funds are more liquid than individual bond issues.
The biggest drawback to bond funds - and it's a whopper - is that they don't have a fixed maturity, so that neither your principal nor your income is guaranteed. Fund managers are constantly buying and selling bonds in their portfolios to maximize their interest income and capital gains. That means your interest payments will vary, as will the fund's share price.
For this reason, don't choose a fund based only on its yield. Look at its total return, which combines the income the fund paid out with any change in the value of the fund's shares. Also, look for a fund with low expenses. (see also: "Different types of bond funds" and "Guidelines for choosing bond funds.")
Because bond funds with similar investment objectives tend to hold similar types of securities, which perform similarly, there are only two ways a fund manager can goose the yield: cut expenses or take on more risk. If a fund's yield is more than 1 percentage point higher than the average for its peers and the difference can't be explained by lower fees, the manager is probably dabbling in exotica.

Money 101, Financial Education. Lesson # 6 Investing in Mutual Funds

Top things to know
1. What exactly is a mutual fund?
A mutual fund pools money from hundreds and thousands of investors to construct a portfolio of stocks, bonds, real estate, or other securities, according to its charter. Each investor in the fund gets a slice of the total pie.
2. Mutual funds make it easy to diversify.
Most funds require only moderate minimum investments, from a few hundred to a few thousand dollars, enabling investors to construct a diversified portfolio much more cheaply than they could on their own.
3. There are many kinds of stock funds.
The number of categories is dizzying. Some examples: growth funds, which buy shares of burgeoning companies; sector funds, which buy shares of companies in a particular sector, such as technology or health care; and index funds, which buy shares of every stock in a particular index, such as the S&P 500.
4. Bond funds come in many different flavors too.
There are bond funds for every taste. If you want safe investments, consider government bond funds; if you're willing to gamble on high-risk investments, try high-yield bond funds, also known as junk bond funds; and if you want to keep down your tax bill, try municipal bond funds.
5. Returns aren't everything - also consider the risk taken to achieve those returns.
Before buying a fund, look at how risky its investments are. Can you tolerate big market swings for a shot at higher returns? If not, stick with low-risk funds. To assess risk level, check these three factors: the fund's biggest quarterly loss, which will help you brace for the worst; its beta, which measures a fund's volatility against the S&P 500; and the standard deviation, which shows how much a fund bounces around its average returns.
6. Low expenses are crucial.
In order to cover their expenses - and to make a profit - funds charge a percentage of total assets. At no more than a few percentage points a year, expenses may not sound substantial, but they create a serious drag on performance over time.
7. Taxes take a big bite out of performance.
Even if you don't sell your fund shares, you could still end up stuck with a big tax bite. If a fund owns dividend-paying stocks, or if a fund manager sells some big winners, shareholders will owe their share of Uncle Sam's bill. Investors are often surprised to learn they owe taxes - both for dividends and for capital gains - even for funds that have declined in value. Tax-efficient funds avoid rapid trading (and high short-term capital gains taxes) and match winning trades with losing trades.
8. Don't chase winners.
Funds that rank very highly over one period rarely finish on top in later ones. When choosing a fund, look for consistent long-term results.
9. Index funds should be a core component of your portfolio.
Index funds track the performance of market benchmarks, such as the S&P 500. Such "passive" funds offer a number of advantages over "active" funds: Index funds tend to charge lower expenses and be more tax efficient, and there's no risk the fund manager will make sudden changes that throw off your portfolio's allocation. What's more, most active mutual funds underperform the S&P index.
10. Don't be too quick to dump a fund.
Any fund can - and probably will - have an off year. Though you may be tempted to sell a losing fund, first check to see whether it has trailed comparable funds for more than two years. If it hasn't, sit tight. But if earnings have been consistently below par, it may be time to move on.

What is a mutual fund?
Adapted from The Right Way to Invest in Mutual Funds (Warner Books, 1996) and Investing for the Financially Challenged (Warner Books, 1999), both by MONEY Magazine senior editor Walter Updegrave.
A mutual fund pools money together from thousands of small investors and then its manager buys stocks, bonds or other securities with it.
When you contribute money to a fund, you get a stake in all its investments.
That's a big deal: Since most funds allow you to begin investing with as little as a couple thousand dollars, you can attain a diversified portfolio for much less than you could buying individual stocks and bonds. Plus, you don't have to worry about keeping track of dozens of holdings - that's the fund manager's job.
The price for a share of a open-end fund is determined by the net asset value, or NAV, which is the total value of the securities the fund owns divided by the number of shares outstanding.
If a mutual fund has a portfolio of stocks and bonds worth $10 million and there are a million shares, the NAV would be $10. A fund's NAV changes every day, depending on the price fluctuations of the fund's holdings.
The NAV is the price at which you can buy and sell shares, as long as you don't have to pay a sales commission, or "load." You have to pay loads when you buy from a broker, financial planner, insurance agent or other adviser.

Different types of stock funds
When searching for stock mutual funds, you're going to run into all sorts of names and categories. They are usually pretty broad and sometimes misleading, but at least they give you an idea of what you are getting yourself into.
Here are some of the most common categories and sub-categories.
Value funds
Value fund managers look for stocks that they think are cheap on the basis of earnings power (which means they often have low price/earnings ratios) or the value of their underlying assets (which means they often have relatively low price/book ratios).
Large-cap value managers typically look for big battered behemoths whose shares are selling at discounted prices. Often these managers have to hang on for a long time before their picks pan out.
Small-cap value managers typically bottom fish for small companies (usually ones with market value of less than $1 billion) that have been shunned or beaten down by other investors.
Growth funds
There are many different breeds of growth funds. Some growth fund managers are content to buy shares in companies with mildly above-average revenue and earnings growth, while others, shooting for monster returns, try to catch the fastest growers before they crash.
Aggressive growth fund managers are like drag racers who keep the pedal to the metal while taking on some sizeable risk. These types of funds often lead the pack over long periods of time - as well as over short periods when the stock market is booming - but they also have some crack-ups along the way.
Growth funds also invest in shares of rapidly growing companies, but lean more toward large established names. Plus, growth managers are often willing to play it safe with cash.
As a result, growth funds won't zoom as high in bull markets as their aggressive cousins, but they hold up a bit better when the market heads south.
Consider them if you're seeking high long-term returns and can tolerate the normal ups and downs of the stock market. For most long-term investors, a growth fund should be the core holding around which the rest of their portfolio is built.
Growth-and-income, Equity-income, and Balanced funds
These three types of funds have a common goal: Providing steady long-term growth while simultaneously throwing off reliable income. They all hold some combination of dividend-paying stocks and income-producing securities, such as bonds or convertible securities (bonds or special types of stocks that pay interest but can also be converted into the company's regular shares).
Growth-and-income funds concentrate more than the other two on growth, so they generally have the lowest yields. Balanced funds strive to keep anywhere from 50 to 60 percent of their holdings in stocks and the rest in interest-paying securities such as bonds and convertibles, giving them the highest yields. In the middle is the equity-income class.
All three types tend to hold up better than growth funds when the market turns sour, but lag in a raging bull market.
All of these are for risk-averse investors and anyone seeking current income without forgoing the potential for capital growth.
Specialty and other types of funds
Rather than diversifying their holdings, sector and specialty funds concentrate their assets in a particular sector, such as technology or health care. There's nothing wrong with that approach, as long as you remember that one year's top sector could crash the following year.
They are most appropriate for investors who are interested in a particular theme - say, biotech - but want to defray some of the risk of choosing individual stocks within the sector.

Different types of bond funds

U.S. government bond funds
These funds invest primarily in bonds issued by the U.S. Treasury or federal government agencies, which means you don't have to worry about credit risk. But because of their higher level of safety, their yields and total returns tend to be slightly lower than those of other bond funds.
That's not to say government bonds funds don't fluctuate - they do, right along with interest rates. If you can't tolerate swings of more than a few percentage points, stick to short-term government bond funds.
If fluctuations of 5 percent or so don't cause you to break out in a cold sweat, then you can pick up a bit more yield with intermediate government bond funds. If you plan on holding on for several years and can handle 10 percent swings, long-term government bond funds will provide even more yield.
Corporate bond funds
Funds in this category buy the bonds issued by corporations that may range from well-known household names to obscure widget makers most of us have never heard of.
When researching corporate bonds funds, consider the credit quality of the individual bonds they hold (most hold highly rated bonds, AAA to A minus or A3, but some take more risk by adding small doses of high-yielding junk bonds.) Also consider the average maturity of the bonds - the longer the average maturity, the greater the volatility.
High-yield bond funds
Putting the euphemism aside, these are junk bond funds. They invest in debt of fledgling or small firms whose staying power is untested as well as in the bonds of large, well-known companies in weakened financial condition.
The potential for these companies to default on their interest payments is much greater than on higher quality bonds, but since these funds usually hold more than 100 issues, a default here and there won't capsize the fund.
There is more risk, however, and for that, you get higher yields - usually 3 to 10 percentage points more than safer bond funds. These funds tend to shine when the economy is on a roll, and suffer when the economy is fading (increasing the chance of default).
Who should buy them: Investors who want to boost their income and total returns and can tolerate losses of 10 percent or so during periods of economic turbulence.
Municipal bond funds
Tax-exempt bond funds - also known as muni bond funds - invest in the bonds issued by cities, states, and other local government entities. As a result, they generate dividends that are free from federal income taxes.
The income from muni bond funds that invest only in the issues of a single state is also exempt from state and local taxes for resident shareholders. Once you factor in the tax benefits, muni funds often offer better yields than government and corporate funds.

Guidelines for choosing stock funds

In-depth mutual fund information is widely available, either from the funds themselves or third-party ratings companies like Morningstar. Here are some things to look out for:
1) Opt for funds with low expenses
Fund expenses directly reduce your returns, so you'll increase your odds of success by avoiding funds with bloated expense ratios; that's the annual cost, divided by your investment.
2) Look for consistency of style
For a fund to fit into a diversified portfolio, it's important that the manager stick to a particular investing style. If you bought a fund because you want your portfolio to include, say, small value stocks, then you don't want a fund manager jumping into large growth issues.
3) Consider risk
Returns may vary, but funds that are risky tend to stay risky. So be sure to check out the route the fund took to rack up past gains and decide whether you would be comfortable with such a ride. Here are some risk measures to consider.
Beta measures how much a fund's value jumps around in relation to changes in the value of the S&P 500 index, which by definition has a beta of 1.0. A stock fund with a beta of 1.20 is 20 percent more volatile than the S&P - that is, for every move in the S&P, the fund will move 20 percent more in either direction, up or down.
Standard deviation tells you how much a fund fluctuates from its own average returns. A standard deviation of 10 means the fund's monthly returns usually fall within 10 percentage points of their average. The higher the standard deviation, the more volatile the fund.
Worst quarter is a very straightforward measure of risk: It merely shows the fund's worst quarterly return on record, giving you a feel of what to brace yourself for.
4) Check out past performance relative to peers
When examining a fund's performance, you should look at its long-term record (at least three years and preferably five years) versus that of its peers, as well as how it has fared over shorter stretches.
Compare those results to category averages - you can't really fault a small-cap fund manager for a lousy year if all small-cap funds did poorly. But it's a lot harder to be forgiving if a fund does much worse than all its peers, especially if it does so over a sustained period.
5) Seek low taxes
You can't forget about taxes just because you don't have any intention of selling your fund shares. As a fund owner, you also own all the stocks in the fund's portfolio. If the fund manager sells a stock for a huge capital gain, you'll have to report that gain on your tax return.
6) Steer clear of asset bloat
This is more of an issue with small-cap funds than with large-cap funds. The latter buy big stocks with a lot of shares outstanding, so the manager shouldn't have too much of a problem buying more GE and IBM when investors pour money into the fund.
But since small-cap funds are buying stocks with very few shares outstanding, an extra billion or two in total assets can tie the manager's hands.
To put the additional money to work, the small-cap fund manager may have to drop his standards or accumulate overly large positions in individual stocks, which might limit the manager's liquidity when trading.

Guidelines for choosing bond funds
1) Think low expenses
The single most important thing you can do to earn competitive returns in a bond fund is to opt for those with low expenses. As a general rule, bond index funds will have lower expense ratios than managed funds that invest in, say, munis and junk. With the latter, at least stick with below-average expenses.
2) Stick with short to intermediate maturities
Over the past 20 years or so, long-term bond funds have provided the highest returns, partly because interest rates have steadily declined over that period. That may not always be the case.
What's more, long-term bond funds can be surprisingly volatile. If interest rates rise just 1 percentage point, a long-term bond fund can drop 10 percent or more, wiping out more than a year's interest.
If you're investing for shorter periods - 10 years or less - or if you're using bond funds to add some ballast to a predominantly stock portfolio, then you may be better off with bond funds with short- to intermediate-term maturities - say, five to 10 years.
You can typically get 75 to 80 percent of the return of long-term funds, while incurring roughly 40 percent less volatility.
3) Beware tempting yields
Fund companies know that investors focus on yields. So some do everything they can short of putting the fund on steroids to pump up yields. They may throw some low-grade bonds into a government portfolio, or even invest in international bonds from countries where rates are especially high.
These ploys to boost interest may or may not pay off, but they all involve risks that are difficult to evaluate. A bond fund that's touting much higher yields than funds with similar maturities raises red flags - it's a sign that the fund is doing something much different, and probably much riskier, than its peers.
If a much higher-yielding offering can't explain its outsized yields by having ultra-low expenses, move on (or accept the fact that you're investing in a riskier-than-average fund).

The beauty of index funds
With the best business schools in the country churning out a steady supply of expensively educated MBAs who go to work for fund companies, you'd think funds would have no trouble posting above-average returns.
After all, fund shareholders (that's you) are paying fund managers big bucks to find the best stocks in the market.
The fact is, however, a majority of funds don't beat the market in most years. That is, you're better off buying all the stocks in the Standard & Poor's 500 index or in the Wilshire 5000 index (which includes just about every stock on the New York, American, and Nasdaq stock exchanges) than paying someone to select what he thinks are the best ones.
There are several reasons so many funds fall short.
First, factor in investing costs that fund companies incur - the cost of research, administration, managers' salaries, and so on.
That cost is borne by the shareholders and gets deducted from returns. A fund manager needs to pick a lot of great stocks to make up for those costs.
Index funds, meanwhile, are much lower maintenance and tend to have much lower costs.
There are some caveats. Indexing seems to work better in some areas than others. The case is most solid for large U.S. stocks and bonds, largely because there is so much information on these big securities that it is tough for a fund manager to gain an edge.

When to dump a fund
1) Your fund is a persistent loser
The mere fact that a fund has low returns or even losses isn't a good reason to sell. If the overall market is down, or the specific sector your fund invests in is out of favor, you can't expect your fund manager to be a miracle worker. But if you own a fund that trails similar funds for two years by a substantial margin - say, 2 percentage points or more - think about moving on.
2) The fund's investment strategy has changed
If you've attempted to create a diversified portfolio, then you're probably counting on the managers of all your funds to invest a certain way. The small-cap fund manager should be sticking to small-cap stocks, and the large-cap value fund manager should be buying large-cap value stocks. If they stray, it puts your entire plan in jeopardy.
3) There's been a manager change
Any time your fund gets a new skipper, you should closely monitor the situation to assure two things: first, that the new manager is following the same investing style and strategy as his predecessor; second, that performance hasn't suffered. Give a new manager one year (and no more than two) to prove himself.
4) You could use the tax loss
There are times when you might be able to lower your tax bill by dumping a losing fund yet still pretty much maintain your asset mix. For example, say you own shares in a large-cap growth fund that are worth less than you paid for them.
If you sell, you can use the loss to offset gains in other securities. Then, you can turn right around and buy another large-cap growth fund. Or, you can buy back the very same fund after 31 days.