02 July 2011

Quiz answers Part II

OK, here are the rest of the answers to the financial knowledge quiz question. This entry covers interest rates/bond prices, mortgages, and portfolio diversification.

3.      If interest rates rise, what will typically happen to bond prices?
a.       They will rise
b.      They will fall
c.       They will stay the same
d.      There is no relationship between bond prices and interest rates
e.       Do not know

OK, this one is hard, and I’m not sure that everyone needs to know or understand this on a daily basis but there you have it. The short answer is: Bond prices move inversely with interest rates, therefore if interest rates rise, bond prices will fall.

Here’s the longer answer. A bond is a financial instrument that represents a form of borrowing wherein the borrower or bond issuer, and this can be a company, a city, state or even the federal government, issues debt in exchange for capital and agrees to a schedule of interest payments and repayment of the principal at a specified date.

ABC Company wants to borrow money, so they issue you a bond in exchange for $1,000 and agree to pay you 3% interest (or coupon) per year for ten years, at which time you get your $1,000 back.

So what happens in a week or a month or so when XYZ Company wants to borrow money and is willing to pay 4% interest for borrowing $1,000? They will still pay back $1,000 in ten years, so this is exactly the same as the ABC deal except for the interest rate. Obviously this is a more attractive option for investors, as a 4% return is greater than 3%.

How much do you think someone would offer you for the ABC bond now? If they could take $1,000 and realize a 4% return, do you think they would want to pay $1,000 for a 3% return? Probably not. In fact, they would probably only pay about $920 for that bond.

The point here is that when interest rates go up, there are investments in the marketplace that will earn higher rates of return. Investments like bonds that are tied to lower interest rates will not be as attractive to investors as newer issues that will pay more. Therefore the prices of investments that are tied to lower interest rates will fall in price.

You can see how this works in the other direction, too. If you own an investment that pays 3% and new investments are only paying 2%, then yours will be worth more because it generates a higher rate of return.

Again, this question may be kind of complex for a quiz like this, but it is important financial knowledge.

4.      Is this statement true or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less.
a.       True
b.      False
c.       Do not know

Most households will purchase a home at some point in time and need a mortgage to do so. A mortgage is a big, long-term loan backed by a substantial asset (like a house). The mortgage gets paid on a monthly basis over the term of the loan. The conventional length of a mortgage loan is 30 years, meaning 360 monthly payments. Some mortgage loans are written for 15 years. This question is asking which of these is less costly in the long run.

So, all other things being equal or ignored, let’s look at two mortgages. One is for 30 years and the other is for 15 years. Both have the same interest rate, 5%, and both have the same principal loan value, $100,000. We won’t go into detail on the math, but the 30 year mortgage is repaid with monthly payments of $536.82. The 15 year loan is paid back with a $702.92 monthly payment. That’s a pretty big difference when you are evaluating your monthly expenses! However, let’s take another look at the total cost of the loan.

With the 30 year loan, you will be making monthly payments for 30 years, or 360 payments. We know that the payments are $536.82. This means that you will pay 360 * $536.82 or $193,255.20. With the shorter loan, monthly payments are made for 15 years, meaning that you will spend 180 * $790.92 or $143,342.20. That’s a difference of almost $51,000! Since the amount of the principal for both loans is the same at $100,000, the difference is in the amount of interest paid.

Thus, a shorter mortgage does cost more on a monthly basis, but the borrower ends up paying less overall with the difference being entirely interest. So this is a true statement.

5.      Is this statement true or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.
a.       True
b.      False
c.       Do not know

This question is all about diversification. Have you ever heard the statement “Don’t put all of your eggs in one basket”? That’s all about diversification, too. The idea here is to spread the risk of investing over many assets, and not placing all of your faith on just one company. If you buy a single stock and something bad happens, you have lost your entire investment. If you buy lots of different stocks, then you have spread your risk over many different companies and you chances of losing it all are greatly diminished. However, it can take a lot of money to buy stock in several different companies and a lot of time to do the necessary research to manage your investments. Mutual funds are professionally managed financial entities that buy a wide selection of companies and then repackage them and sell them to investors. That way each investor can share the benefits of ownership of many different companies, diversify risk and generally enjoy a safer return than owning stock in just one company.

There are almost as many mutual funds available as there are individual companies, and they are not all created equal. You still need to be a conscientious investor, but generally speaking, mutual funds offer a reduced risk alternative to owning one individual stock. The statement is false.

I hope that these explanations have been helpful and that you feel more secure in your financial knowledge. While financial knowledge is not the one and only key to financial satisfaction, it is an important component. Remember the motto of Faber College: Knowledge is Good (if you are mystified, it's an Animal House reference). 

No comments:

Post a Comment