A column last month on “strips,” or zero-coupon bonds, prompted many calls and letters from readers eager to buy them and a warning from a financial consultant about the risks they pose.
“Strips, because they pay zero interest, are the absolute most volatile fixed-income vehicle out there,” said Victor Connor, an investment professional for more than 20 years. “In plain English, they go up and down more than any other type of bond. When interest rates go up, they get clobbered.”
I mentioned this, but I suspect the point needs more emphasis. Strips give you a guaranteed return if you hold them until maturity, but you could take a bath if you have to sell early and interest rates have gone up.
“And just when you do think Aunt Bessie decides to sell her strip? When it’s down the most,” Connor said. “In the real world, people panic when prices go down, and they sell.”
You may recall strips are U.S. Treasury securities “stripped” of their interest payments. You buy them at a discount from their face value, which you are guaranteed to receive at maturity. Your profit is the difference between what you pay for them and what you get back.
But while you are holding them, the price of strips can fluctuate wildly, going in the opposite direction of interest rates. So you could either make a quick killing or get killed if you sell before maturity.
Another disadvantage, which I mentioned and Connor wants to stress, is that even though you don’t collect any interest until maturity, you are taxed every year on the assumed or “imputed” interest. “Let’s see what we have,” Connor said. “A risky investment that generates annual tax bills without providing the money to pay the tax.”
That said, I still like strips a lot as long as you are happy with the guaranteed return you lock in when you buy them and are ready to hold until maturity, and if you buy strips as I do in tax-deferred accounts such as IRAs to sidestep the tax problem.
But please look at all the pros and cons and don’t decide to buy something just because you read about it in a newspaper column.
Q–You mentioned that anyone under 55 has to worry about the IRS penalty for early withdrawal for a 401(k). I thought it was anyone under 59 1/2. Please advise because I am 56 and wish I could get all my 401(k) without penalty.
A–You can, provided you have left your job. Then you can take the money out of your 401(k) plan without penalties at 55, although you will still owe the regular tax.
But whether you are employed or not, money from an individual retirement account generally cannot be taken out without a 10 percent tax penalty until you reach 59 1/2.
Q–Recently you discussed the importance of checking to be certain that a mortgage holder gives you the proper credit for any additional payments you make to the principal.
Carrying this one step further, is there a simple formula to determine if the mortgage holder properly determines how much is interest and how much is principal in future monthly payments, once an extra payment has been made to reduce the principal?
A–Yes, there is. Anytime you make a regular payment on a mortgage, you can calculate how much is interest and how much is principal. And you should, because when you start making extra payments to principal you change the original amortization schedule your lender gave.
You need to know only three things: the outstanding balance on the mortgage loan, the interest rate you are being charged and what the combined payment is for principal and interest (exclude any part of the payment that’s for taxes or insurance).
First, determine what the interest would be on the outstanding balance for a full year by applying the interest rate to the balance. Divide the result by 12 to find out how much interest is due the next month. Subtract that number from your total payment for interest and principal. What remains is what your lender needs to credit to the principal.
Say your mortgage balance is $70,000. The interest rate is 7.5 percent. Monthly payments for principal and interest are $900.
Calculate total interest for the year, or 7.5 percent of $70,000. That’s $5,250, or $70,000 divided by 100 and multiplied by 7.5. The interest for the next month is $437.50, or $5,250 divided by 12. You can see that your $900 payment consists of $437.50 interest and $462.50 principal. Your new principal balance must be $69,537.50.
If now you can figure out on your own that the following month’s payment will be $434.61 interest and $465.39 principal, you’ve got it.
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Humberto Cruz welcomes questions and comments from readers. Although he cannot respond to each one individually, he will answer questions of general interest in his column. Send e-mail messages to: HCruz5040(at)aol.com. Write to Mr. Cruz c/o Tribune Media Services, 435 N. Michigan Ave., Suite 1400, Chicago, Ill. 60611.
