ARM Yourself for Mortgage Rate Increases (2006-07-31)

ARM Yourself for Mortgage Rate Increases

(2006-07-31) by David John Marotta and George Marotta

The party is over for home owners with adjustable rate mortgages (ARMS). Lured by tantalizing rates as low as 3.5 percent in the early 2000s, home buyers jumped at the chance to buy bigger and better. However, in today’s environment, borrowers may not be prepared for their inevitable rate adjustment. The bad news is rates are being readjusted in one direction: up.

What goes down must come up. Since the bygone days of low interest rates, the Federal Reserve Board has raised rates 17 consecutive times over the last two years—from 1 percent to 5.25 percent — and the forecast is only calling for more bad news. The "adjustable" part of the deal may come as a slap in the face as many home owners face their first rate hike any day now. In fact, borrowers could see their mortgage payments increase by more than fifty percent. Here’s why.

Unlike their fixed-rate counterparts, ARMS shift much of the interest rate risk to the borrower. Typically, borrowers are baited with an initial low fixed interest rate for the first three, five, or ten year period. After that, the interest can be adjusted by the lender—upward or downward—yearly. But, in exchange for the borrower assuming more risk, ARMS typically offer lower interest rates than those for fixed-rate home loans.

After enjoying a few years at the fixed interest rate, the rate on the loan is reset annually. ARMS fix their interest rates to an index which tracks the federal funds rate or the T-bill. But the ARM interest rate is not the index rate. On top of the index rate, lenders slap on a "margin" of a few more percentage points. With the new federal funds rate at 5.25 –compared to one percent two years ago— plus the lender’s margin, the "adjusted" rate will soon exceed seven percent.

The average home buyer borrowing $200,000 at 3.5% with a 30-year 3/1 ARM would have enjoyed a monthly payment of $898 for three years. But after the initial three year period, a rate hike of two percent would increase the monthly payments to $1,116 per month, a 26 percent increase.

The good news is most ARMS limit the annual rate increases to two percent. However, the bad news is you’ll probably get hit with another increase next year. An additional two percent increase would bring your monthly payments to $1,349, a 52 percent increase over your initial monthly payment amount.

But, there’s more bad news.

About $1 trillion in adjustable rate mortgages is scheduled to be reset this year and another $1.7 trillion in 2007. The magnitude of these changes has economists worried about what ripple effect these rate hikes might have on the economy.

Part of the panic stems from the widespread use of these relatively new mortgage products. Low interest rates drove the dramatic upswing in adjustables in 2003 and 2004. By 2004, ARMS represented a third of all new mortgages in the US according to a Harvard study on the nation’s housing status. This year, the study estimates one tenth of all homeowners in American will experience a rate increase in 2006.

With $1 trillion in mortgage debt to be reset this year, many Americans are going to have a lot less discretionary cash on their hands... as if rising gasoline prices weren’t enough. These big jumps in monthly payments will push many more home buyers into default.

The inevitable domino effect doesn’t bode well for the financial sector. Alan Abelson of Barron’s Magazine reports as much as 48 percent of bank assets is tied up in mortgage backed securities. With the economy beleaguered by soaring energy costs and two years of interest rate hikes, mortgage defaults due to rate hikes on ARMS will adversely impact American banks— already over-exposed to mortgage debt.

As if the threat of defaulting loan payments wasn’t enough, the housing market continues to cool. Rate hikes are largely responsible for putting the brakes on the housing market as a whole. Sales are down and inventory up.

Last month, Wachovia Securities reported housing inventory up nearly 41 percent over last year. The nation’s five largest home builders posted declines of 32 percent since January. And leading indicators like the National Association of Home Builders/Wells Fargo Housing Market Index which measures confidence in future home sales hit an 11-year low dropping more than 40 percent since last year.

With interest rates at their highest level in five years and the subsequent chill in the housing market, many homeowners and some banks will find themselves right behind the eight ball. In other words, "The party is over."

from http://www.emarotta.com/article.php?ID=189

Foreign Freedom Investing 2006 (2006-07-24)

Foreign Freedom Investing 2006

(2006-07-24) by David John Marotta

On average, international stocks appreciate more than US stocks, and stocks in countries with the most economic freedom appreciate more than the international average. The MSCI EAFE International Index gained 26.6 percent during the one-year period ending June 30, 2006, and averaged 23.9 percent annually for the past three years. And, stocks in the ten most economically free countries gained 24.5 percent during the past year, averaging 27.3 percent annually for the past three years.

For small accounts, investing in a good international fund is sufficient diversification. Greater diversification and returns can be gained by putting some funds into emerging markets which appreciated 35.5 percent over the past year and averaged 34.3 percent over the past three years. Emerging market returns were exceptional due in part to Brazil which posted gains of 64.9 percent. Although emerging markets typically do better, they are inherently more volatile.

To balance performance and stability, a simple foreign asset allocation might invest two-thirds in the MSCI EAFE Foreign Index and one-third in the MSCI Emerging Markets Index. Using this technique, you would have gained 29.5 percent for the past year and averaged 27.4 percent over the past three years.

For larger accounts, a more complex asset allocation should be used. This asset allocation strategy takes advantage of the fact that economic growth is often better in those countries with the greatest economic freedom. We use the Heritage Foundation's measurement of economic freedom to emphasize those countries that combine the greatest economic freedom with large investable markets.

According to the Heritage study, "Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

A country’s economic freedom score is based on fifty measurements that fall under the following categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

Several of the twenty countries to receive a "free" ranking have easy, convenient and inexpensive ways of investing in the market using country-specific iShares. iShares are exchange traded funds (ETFs) which combine the liquidity of individual stocks with the diversification of index funds. The iShares Funds also have lower expense ratios than most mutual funds.

Since its inception in 1994, the Heritage Foundation Index of Economic Freedom has used a systematic, empirical measurement of economic freedom in countries throughout the world. The conclusions from this study clearly demonstrate that countries with economic freedom also have higher rates of long-term economic growth. That makes the study useful for investors to decide which countries should be emphasized in their foreign stock allocation.

For larger accounts, we invest half of the assets using the simple technique described above. As such, one-third is invested in the MSCI EAFE index (EFA) and one-sixth in emerging markets. The other half is divided evenly among the ten countries with the most freedom that also have markets large enough to have a country-specific exchange traded fund.

The top ten most economically free countries all beat the United State's 8.2 percent return. In descending order of the past year’s return was Canada at 31.6 percent, Germany at 30.0 percent, Switzerland at 29.6 percent, Austria at 28.7 percent, Sweden at 27.2 percent, the Netherlands at 23.1 percent, Singapore at 21.2 percent, the United Kingdom at 20.9 percent, Australia at 20.6 percent, and Hong Kong at 12.1 percent. Over the past year, five of these countries beat the MSCI EAFE Foreign Index and five fell short.

The EAFE Index did well in part due to Japan's stellar 35.9 percent returns. Normally, we don’t recommend specific investments in Japan. While this year has been good, Japanese returns averaged a 0.1 percent loss over the last ten years.

This year however, Japan's economic freedom score rose significantly making Japan the 27th freest country. Japan's recent 35.9 percent return and 25.1 percent three-year average suggest that the Japanese economy may be rebounding from its malaise.

Averaged together, the top ten "free" countries gained 24.5 percent this past year and averaged 27.3 percent over the past three years. While Japan’s returns over the past year brought the international index up, over the past three years investing in the ten countries with the most economic freedom surpassed the EAFA Foreign Index by an annual 3.3 percent.

Diversifying your foreign investments is just one important component of an optimal asset allocation. Building balanced portfolios that are more likely to meet your financial goals doesn’t happen casually or by working with someone whose interests are in conflict with yours. Visit NAPFA (www.napfa.org) to find a Fee-Only advisor in your area or call NAPFA at 1-800-366-2732.

from http://www.emarotta.com/article.php?ID=188

Socially Responsible Investing (2006-07-17)

Socially Responsible Investing

(2006-07-17) by David John Marotta

The oldest socially responsible index is called the Domini Social 400. The index screens stocks it considers inappropriate out of the S&P 500 and then adds favored companies from the Russell 1000. Using the S&P 500 Index or a similar derivative as the backbone of your investment portfolio is a risky strategy that increases the danger of you failing to meet your financial goals.

Socially responsible investing based on deleting stocks from the S&P 500 only amplifies the inherent weaknesses of the S&P 500 as an investment index. Many of the stocks that are deleted from the S&P 500 are value stocks and not growth stocks. As a result, the Domini Social Equity fund (DSEFX) is overweighted towards more expensive (high P/E) growth stocks and has a portfolio beta slightly greater than 1.00. Volatility is greater than that of the S&P 500, which can increase your portfolio risk.

If the S&P were a financial advisor it would say, "Let’s buy mostly large cap growth stocks in the industry that did well last year with a high price per earnings ratio." This advice results in a very aggressive and very volatile portfolio that does better at the end of a bull market than at the beginning. And it will do very poorly at preserving capital during a prolonged bear market - exactly what happened over the last six years

During the last half of the 1990’s, socially responsible investing could claim its returns beat the S&P 500, but the cause was better attributed to increased risk than to social consciousness. In 2000, when growth fell out of favor and value came back into favor, the Domini Social Equity fund started underperforming the S&P 500 significantly and still has not recovered.

The weaker returns can be attributed in part to the screens eliminating more value stocks. Another drag on returns is the fact that socially responsible investment products typically have higher expense ratios. The Domini Social Equity Fund, for example, has an expense ratio of 1.13% and a 12b-1 fee of 0.25% for a total expense ratio of 1.38%. By comparison, iShares S&P 500 Index Fund (IVV) has an expense ratio of 0.09% and the Vanguard 500 Index Fund (VIIIX) has an expense ratio of just 0.18%.

Often, socially responsible funds fail to meet our investment criteria which include several different factors in addition to expense ratio. In only four of the last twelve quarters has Domini Social Equity scored in the top quartile of large blend funds, and in six quarters they scored in the third quartile according to the Center for Fiduciary Study’s ranking. Its three year average score is 40 on a scale of 0 (perfect) to 100 (worst).

One of the problems with socially responsible funds is that they are not always a financially responsible way to best ensure that you reach your goals. Socially responsible funds rarely use the criteria that an informed investor would use. Most avoid "sin" stocks such as gaming, liquor and cigarettes. Few people dislike cigarettes as much as I do, having lost close family members to cigarette-related illnesses, but even these simple screens are suspect.

Altria Group (MO), formerly Philip Morris, changed its name and its business structure when it purchased Kraft Foods and expanded its business to include product lines in 99% of American households. It is more harmful not to buy a company’s products than it is not to buy their stock, but it seems ludicrous to punish Altria for expanding its business model to include healthier products.

On the other end of the spectrum, last year, Pax World fund (PAXWX) sold its entire position of 375,000 shares of Starbucks Coffee (SBUX) worth $23.4 million just because Starbucks entered into a deal to sell a coffee-based alcoholic beverage. There are much worse sins than putting a little whiskey in your coffee.

If you put so many constraints on your portfolio that you cannot meet your financial responsibilities, then you have taken the speck out of your brother’s eye but failed to notice the log in your own eye. It is impossible to create as well diversified a portfolio using funds that claim to be socially responsible as it is to use the full spectrum of investment options.

While the number of fund’s claiming to be socially responsible has grown, the contradictory natures of their screens have also become apparent. Some funds will only invest in company who support homosexual marriages while other funds shun those exact same companies.

One fund refuses to buy any companies involved in the extraction of natural resources, which has been a top-performing sector over the last few years. Energy, mining, and lumber companies are eliminated entirely in this particular fund’s screens. Even the process of putting together the fund’s annual report would be impossible with that screen. From the electricity for the fund’s computers to the staples that hold the recycled paper pages together, the fund is willing to buy the products of the companies whose stock it refuses to buy.

Nearly every company has positive and negative aspects. Take, for example, Southern Peru Copper Corporation (PCU). Many mining companies are excluded on environmental issues alone. Southern Copper has been working at modernizing its smelting process in order to satisfy the company’s environmental agreement with the Peruvian government. Should an advisor shun investing in those electronic companies that purchase from the most inexpensive source of copper, often the company with the worst environmental process?

Because of its extremely high conductivity, sixty percent of copper is used in electrical and electronic goods. Even if an investor decided not to invest in Southern Peru Copper Corporation, it is unlikely that an advisor or client would go as far as boycotting purchasing the electronics that cause the demand for copper in the first place.

Seeking to use your investment selection in order to be socially responsible is misguided. Though it may assuage a guilty conscience, it is an ineffective tool for corporate change. While it gives the appearance of taking a stand for certain values, it dodges the difficult issues that shareholders bear.

The importance of handling your finances as a responsible steward is usually not best served by utilizing funds claiming social responsibility. While there are companies whose business may best be avoided, delegating that selection criterion to a fund’s screening process is like use a blunt instrument to do brain surgery. Better is having a financial advisor who gets to know you personally and manages your finances according to your specific values.

from http://www.emarotta.com/article.php?ID=187

Avoid Capital Gains Tax on the Sale of Your Home (2006-07-10)

Avoid Capital Gains Tax on the Sale of Your Home

(2006-07-10) by David John Marotta

If you own a home you are likely aware of the tax benefits such as deducting your mortgage interest and property taxes. However, you may not be aware of the tax-free earnings you can take after you sell your home. Under the Taxpayers Relief Act of 1997, capital gains generated from the sale of a primary residence are tax-free. Individuals pay no taxes on profits up to $250,000. And, couples are allowed to combine their tax credit and exclude up to twice the amount from a home sale.

The income exclusion is so lucrative many homeowners have adopted a lifestyle of home improvement with the hopes of buying low, selling high and making a handsome tax-free profit every two years. A little elbow grease invested in home improvements can generate a handsome reward on the day of sale. Imagine selling your home at a significant markup and paying no taxes on that income.

Previously, profits from the sale of a home automatically triggered capital gains tax, unless that is, you plunked the profits back into another home with a bigger price tag. The only other option was a one-time exclusion of $125,000 if you were over 55. Under current tax law, there’s no need to apply your gains to the purchase of another home. Profits can be spent on a trip to Europe, or better yet, saved and invested.

Capital gains is figured by taking the sale price of the house and subtracting your closing costs, realtor fees, and cost basis (what you paid for the house plus any significant house repairs). What’s left is your profit, or capital gains. If you are filing individually, any profits up to $250,000 ($500,000 if you are a couple) are yours to keep, tax free!

Let’s consider an example. The Smiths purchased their home for $100,000. Over the years, they invest another $50,000 in renovations into the house. Once the kids leave for college, they decided to downsize. With many years of appreciation, the Smith’s home sold for $500,000. Fees and realtor’s commission aside, their profit on the house was $350,000 ($500,000-$150,000). Under the Taxpayer Relief Act, the Smiths pay no taxes on the $350,000 profit. Not bad.

As with any great offer, there is of course, the fine print at the bottom. For one, you can only claim the exclusion every two years. And to qualify, you’ll need to pass two important tests: the "ownership" and "use" tests.

The "ownership" test requires you to have owned the home for two years. To pass the "use" test, you must have lived in the home as your primary residence for two of the past five years. Your two years can be a combined total of 760 nonconsecutive days over a five-year period in which you lived in the home as your primary place of residence.

Let’s look at another example. Newlyweds, Jack and Jill live in Manhattan. After their wedding, Jack moved into Jill’s townhouse, a home Jill had owned for the previous five years. Soon after their wedding, Jack and Jill decide to sell the home. They sell the home and make a profit of $400,000.

In this example, although Jack and Jill were just married and ownership moved from individual to joint ownership, the home has not changed hands. Uncle Sam will allow them to pass the ownership test. But, to pass the "use" test, both parties must live in the house for two of the past five years. In this case, only Jill meets the criteria, so only $250,000 of the earnings can be excluded. Jack and Jill will have to pay capital gains tax on the remaining $150,000.

Waiting until the two-year anniversary to sell your home will likely be worth the wait. Homeowners who sell their home before they reach the two-years mark will find no pot of tax-free gold at the end of the rainbow. Any profits generated from the sale of a home which exceed your exclusion limit will be taxed at the long-term capital gains tax rate of either 5 or 15 percent, depending on your tax bracket.

Profits from the sale of a home owned for more than one year but less than two years will be taxed at the long-term capital gains of either 5 or 15 percent. Worse yet, homeowners buying and selling within a one year period are taxed at the ordinary income rate, anywhere from 10 to 35 percent.

There are, however, some welcome exceptions to the rules. If you are divorced and gained full ownership of your home as part of a divorce settlement, you are permitted to take the full exclusion of up to $500,000, assuming you still pass the two-year "use" test.

Members of the armed forces who are forced to relocate can take the full exemption regardless of how long they have owned their home. Homeowners forced to relocate due to health reasons, divorce, or job reassignments may take a pro-rated exclusion if they don’t meet the full two-year "ownership" and "use" tests.

If you are hoping to sell your vacation house - the one you visit for two weeks out of the year - you won’t qualify you for the exemption. However you might consider moving your official place of residence to your vacation house, live in it for two years, and then take the exclusion.

In May 2006, President Bush signed into law new tax laws extending the lower capital gains tax rates until 2010. Through 2010, sellers who turn a profit over and above the exclusion limits will pay a maximum capital gain tax of 15 percent. Sellers in the lowest two tax brackets will see their capital gains rate of 5 percent in 2006 and 2007 drop to 0 percent from 2008 through 2010. After 2010, all long-term capital gains tax will move back up to 20 and 10 percent respectively.

Of course, these considerations alone should not dictate when you sell your home but should be part of your overall financial plan. Visit the National Association of Personal Financial Advisors (www.napfa.org) to find a fee-only advisor in your area.

from http://www.emarotta.com/article.php?ID=186

The United States - Land of the Free (2006-07-03)

The United States - Land of the Free

(2006-07-03) by David John Marotta

This year, the US reclaimed its spot among the top ten countries in the world with the most economic freedom according to The Wall Street Journal/Heritage Foundation 2006 Index of Economic Freedom. But for a nation which considers itself a paragon of liberty, watching other countries enjoy more economic freedom than we Americans comes as an affront to our self image.

Economic freedom is, essentially, the ease with which goods and services can be exchanged between individuals, corporations, or countries. Put another way, it is a measure of your freedom to create wealth by engaging in all kinds of economic activities such as starting a business, securing a home loan, opening a bank account, or investing your savings.

According to the 2006 report, Hong Kong - despite its forced allegiance to China - maintained its status as the most economically free "country" in the world. Following Hong Kong’s lead, Singapore, Ireland, Luxemburg, Iceland, the UK, Estonia, and Denmark all outstripped the US in the Index ratings. And moving up from twelfth place, the US tied for ninth place with Australia and New Zealand.

Economic freedom is the key to creating and sustaining wealth. Although the notion of economic freedom is nothing new, the Index quantifies this relationship between economic freedom and a nation’s wealth. The data shows that people in economically freer countries are wealthier than people in countries with less economic freedom.

The 2006 Index ranked 161 countries in ten categories to determine the level with which its citizens could engage freely in business. Countries were given a score and ranked as either "free", "mostly free", "mostly unfree," or "repressed."

Individual living in "mostly free" countries earned on average 70 percent more than those among "mostly unfree" and "repressed" countries. And among the 20 "free" countries, average per capita income figures more than double those of "mostly free" countries.

On a global scale, economic freedom saw a net increase over the previous year. Three countries were added to the "free" list bringing the total to 20. All told, 99 countries became freer economically, whereas only 51 countries saw declines.

The US is one such country which has made small strides to regain some economic freedom, in large part due to the Bush tax cuts. US economic freedom also translates into better stock market returns. Even including the recent market corrections, as of the end of May, 2006, the S&P 500’s 3-year average return was 11.64% and its ten year average return was 8.35%.

Although the US is doing well, other countries are catching up and even passing us in relative freedom. Since 1994 when the Index was first released, the US has dropped from fourth to tenth place, scoring as low as twelfth place in 2005.

Jefferson warned us that the price of freedom is eternal vigilance. We cannot naively assume that we will always remain the world’s champion of freedom. Regarding the United States, the 2006 report blames government entitlement programs such as the 2002 farm subsidies legislation, the 2003 Medicare prescription drug program, and the 2005 transportation bill for saddling the American economy with unnecessary fiscal burdens. And it points to legislation like Sarbanes–Oxley which has significantly raised compliance costs.

The United States must continue to compete in the world market of economic freedom or accept a western European style decline into socialism. Many countries are choosing to compete. Ireland has lowered corporate taxes and has become a small Mecca for foreign investment.

Five more countries in Eastern Europe embraced a flat tax last year bringing the number to a dozen. Austria has benefited from the economic freedom of the region and in the 2006 report crossed from one of the highest "mostly free" countries into the "free" category.

Our founding fathers established a country in which its citizens could engage in business activities without government encumbrances. In his first inaugural address, Thomas Jefferson underscored the importance of economic freedom for Americans declaring, "A wise and frugal government shall restrain men from injuring one another, shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned."

As we celebrate our many freedoms this Independence Day, let us be mindful of the ongoing fight for freedom both here and around the world.

from http://www.emarotta.com/article.php?ID=185