Should You Buy Dividend Paying Stocks?


Ask SmallIvy

In stock investing,  it really all comes down to dividends.  Either dividends that the companies you own currently pay, or dividends they may pay in the future.  Indeed, the price growth rate of a stock is normally tied to the growth rate of the dividend, both the one that it pays now and the one that it will probably pay in the future.

You see, a dividend is a portion of the profit that a company makes that it pays out to the owners – the stock holders.  When a stock is young and growing rapidly, it may pay only a small dividend, or even no dividend at all,  because it needs all of the money it can raise to grow the company.  When it becomes a big company many years later, however, it might making enough money to pay out a few dollars per share each year.

The nice thing about dividends is that they allow you to make money from a stock even in years where the prices of stocks are gong nowhere.  If you own shares in a stock that pays no dividend and the price just trades within a narrow range for several months, you will have received no return for your money during that period.  If the stock pays a dividend, however, you can still be making a few percentage points of return each year even when the price of the stock is going nowhere.  It is kind of like a bank account with the possibility of much bigger gains.  (Realize, however, that movements down in price can quickly erase the amount of money you are getting from dividends, so there is no stability or guarantee like there is with a real bank account.)

Often a company will continue to pay dividends even when the price of the stock declines, helping to reduce the sting of the loss.  In addition, because the percentage return (yield) of a stock will increase as the stock price goes down unless the company decides to cut the amount of its dividend, people are more likely to buy dividend paying stocks as they decline than those that don’t pay a dividend.  This causes something like a safety net to be placed under the price of the stock.  Of course this doesn’t work in cases where the business of the company declines since then they may need to cut or eliminate their dividend.

Despite the virtue of dividend paying stocks, they aren’t for everyone.  If you are young and have s long time to invest, you’ll generally do better buying a portfolio of young companies that don’t pay dividends but have a lot of room to grow than you will with older companies that pay a good dividend but have already seen a lot of their growth.   Dividends will also create income, which means you’ll need to pay taxes each year even if you reinvest the dividends unless the stocks are in a tax-deferred account like an IRA.

Dividend paying stocks can be great, however, if you need your portfolio to generate an income for you.  If you receive enough money from dividends to pay for things when you’re retired, you will not need to sell shares of stock to raise cash.  You can then let the value of the shares appreciate while you spend the dividends.

Another neat thing about dividend paying stocks is the compounding that comes.  When you start out, you may only be making a 2-3% return each year in dividends.  As the company grows, however, and makes more money, they may increase their dividend.  Because the stock price increases they may still only be paying 2-3% based upon the price of the stock, so you’ll effectively be making a greater return on the amount of money you invested.  Wait long enough and you may be making a 10, 20, or even 30% return based on your original investment each year!  The power of compounding, even when it comes to dividends, is astounding.

When investing in dividend paying stocks, here are some things to consider:

1.  To save taxes, keep your dividend paying stocks in tax sheltered accounts and non-dividend paying stocks in taxable accounts unless you need to spend the money now.

2.  Companies that raise their dividends every year tend to be great companies as long-term investments.  Find these and hold on.

3.  Don’t buy a stock with a dividend that is much bigger than the rate of similar stocks in the market.  It is probably about to cut the dividend.

4.  If you don’t need the money for a while, consider using a dividend reinvestment plan, or a DRIP, where the dividends are reinvested to buy more shares.  Again, this will need to be in a tax-sheltered account or you’ll still need to pay taxes on the dividends.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Tame your Credit Cards


IMG_0119Generally, credit cards and personal finance don’t mix.  There are many reasons:

  1.  Credit cards allow you to get into debt.
  2. Credit cards have usurious interest rates.
  3. You’ll spend more with a credit card than with cash.
  4. Credit cards can zing you with fees and interest.

Generally, I would say that handling credit cards is like snakes – eventually they will bite you.  And bitten I have been – like about ten years ago when I wrote my regular monthly check to pay off my credit card balance in full, as I did every month, but forgot to write the hundreds amount in the written out line (the amount was correct in the box.)  The result was interest charges for that month and the next month (they didn’t make any attempt to contact me about the obvious mistake – they just quietly cashed the check for the lesser amount).  This caused interest payments of about forty dollars and my closing the account when they wouldn’t refund the interest.

I have started to dip my foot back into credit after spending several years with just a debit card.  Normally I use a debit card that goes with my brokerage account.  The beauty of that arrangement, as opposed to using a standard bank debit card, is that the brokerage margin account backs up the debit card.  You see, with a regular bank account, if I put too much on the debit card and write too many checks, I can overdraw the account and end up with a lot of returned check fees and mad merchants.  This is easy to do with a debit card unless you carry your check register with you and record the debit charges as you go.  With the brokerage account backing up the debit card, if I do charge more than the cash in the brokerage account, I just go a little into margin, which charges a fairly low interest rate.

Now I don’t normally live in margin.  I generally keep enough to cover my normal monthly charges, plus a couple of thousand dollars extra, in the brokerage account. If I have an extra charge in a month, I may sell some shares off early to raise cash or send money into the account.  If I do find that I have gone through all of the cash in the account, which happens maybe once every few years, I can just sell some shares and get out of margin.

About a year ago, I did decide to switch from the standard debit card into a credit card with the brokerage firm.  The reason is that the credit card offered cash back rewards.  I was skeptical, having been bit before and finding out that the charges when you make a mistake can far exceed the rewards you may be receiving.  I reluctantly decided to try the credit card again, however, since the broker offered an automated payment service, where the statement balance for the credit card was automatically sent from the money market account in my brokerage account when the payment was due.

So far this has worked, although there are a few things I didn’t expect that I generally don’t like.  Here are some of the issues:

A balance can still build.

The main issue I’ve found is that only the statement amount due is paid automatically at the end of the month, rather than the full balance on the card at that time being paid.  This results in about one month’s worth of charges being on the card all of the time since about a month passes between the time that the statement comes and the balance is paid.  This reduces the effective amount of credit I have, making me worried about hitting the credit limit on extraordinary months such as when I have a business trip on the card or have made a large purchase.  The automated payment also happens late in the month, which further increases the balance on the card before it is paid.  There have been a few months where I have been nervously tracking the amount of credit I have left on the card and waiting for the automated payment to be sent.  At one point I went ahead and asked for the credit limit to be raised by a few thousand dollars to put the ceiling a little higher, which was granted.

I also discovered this month that I can call in and have a special payment made.  I went ahead and paid off the full balance of the card, so it now has almost a zero balance.  I will probably go ahead and do this every few months, or if I know that I have some big charges coming up due to a vacation or something, to keep a balance from building up.  I also just like to get rid of debts as quickly as I can.

Easy money can lead to over spending.

I do wonder about the effect on our spending from using a credit or even a debit card.  We pull out cash each month for what we call “entertainment” – mainly meals out about once a week and personal “blow money” – cash spent however you wish, no questions asked.  I do find, however, that there are times when we’re out somewhere and the credit card will get whipped out for a meal or something.  This is usually when we need to eat out since we’re out somewhere and can’t make it home for lunch or dinner.  It also hurts a lot more to pull out fifty or sixty dollars for a meal than it does to put the same amount on the credit card, so I find there are more meal expenses on the credit cards than I’d like to stick to our budget.

Probably a worse place for overspending due to using a credit card is stores.  It is truly amazing how little you can put into your cart nowadays and see a bill of more than $100.  Sometimes I’ll go to the grocery store or Wal-Mart, buy just a few things, and walk out with a $60 bill or something.  Our debit and credit cards actually also provide a year-end summary of charges, and we found that we spent about 40% of our money in two places – Kroger and Wal-Mart.  This is generally groceries and stuff for the home, toiletries, and so on.  Still, I wonder if we would have spent as much if we were paying cash.  That would be a  lot of cash going over the counter each week.

Gift cards that don’t get used.

Generally I trade in the points we earn for gift cards.  I found that if I get at least a $50 gift card, we get about 1% cash back from the credit cards for things like restaurants and home improvement stores.  So far, however, we haven’t done a good job of using those cards once we get them.  They generally sit in the drawer, forgotten about.  We really need to do a better job of actually using the cards, perhaps pulling out less cash for meals out on some months since we have the gift cards.  We also need to avoid the “Costco effect” – where you eat an entire gallon jar of cherries in a week because you bought a giant jar of cherries since it was such a “great deal.”  We need to make sure we use the gift cards to replace spending we would do otherwise, rather than just go out more to use of the gift cards.

So, I’m still not sure about reentering the credit card world.  So far things seem to be going all right, but I wouldn’t be surprised to get bit at some point.  It definitely distorts our finances since we buy things in one month and then pay for them in the next, making it tough to keep track of spending and to budget.  If you have a credit card due in May, but spent the money on things in April, which month do you put it in?  You also can’t just look at bank account balances at the end of the month to see how much you are spending.   I think we are also spending more than we would with cash.

Thanks to reader, Jessica, who suggested the topic for this post.  Keep them coming!

Your investing questions are wanted. Please send tovtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

 

Poisonous Debt


Spider

There is probably no good debt, although some people may debate and say that a home mortgage is a good debt because it allows you to stop paying money to rent and helps build your credit.  Still, even with a home mortgage, it is usually better to pay the debt off than it is to hold onto a home mortgage.  Doing so allows you to stop paying interest on the loan, which means more money in your pocket for saving and investing.  It also reduces your risk since all you need to then do to keep your home is keep paying the property taxes.  If you lose your job, all you need to do is pull together maybe a couple of thousand dollars per year and you won’t need to worry about keeping a roof over your head.

Still, mortgage debt isn’t what I would call poisonous debt – debt that is very difficult to control and that will tend to grow with time unless you are very diligent.  That kind of debt has the following characteristics:

1.  It has a high interest rate.  Take 72 and divide by the interest rate.  That simple calculation will tell you how many years it would take a debt to double if left alone.  If you have a 4% home loan, it will take a little less than 20 years to double, meaning that you will pay about twice the loan amount for your home by the time you pay off a 30-year mortgage.    For a 20% interest credit card, it will double about every three and a half years.  Take three years to pay off something you buy on a credit card, and you’ll pay double.  How’s that $14 latte taste?

High interest makes a debt poisonous because you end up paying a lot of interest each month, so the total amount of the debt rarely goes down.  For example, if you owe $10,000 on a credit card at 20% interest, the first $167 you pay just goes towards paying down the interest.  Pay $250 and you’ll only knock the balance down by about $83.  If you make $30 per hour after taxes, that means you’re working the better part of a day per month just to pay the interest on your credit cards!

2.  It is for something that goes down in value.  If you take out a loan to buy something that goes up in value like a home, the increase in the value over time will reduce the amount you actually pay for the item.  This, in addition to the effects of inflation, help you get rid of the debt.  Plus, when you’re done you have something for all of the money you’ve paid.  Buy something like a car on credit, however, and you may very well owe more on the car than it’s worth during most of the time that you have the loan.  By the time you finally pay off the loan and own the car, it may be time to buy another one if you take out a 6-year loan.  At the end of the car loan, all of the money you paid is just gone.

3.  It has a variable interest rate.  You must remember that the lender is in control when you have a loan.  The only thing worse than owing money is owing money where the lender can change the terms on you.  You don’t want a loan like a variable rate home loan or a credit card where the payments may rise to the point where you cannot afford to make them.  You also don’t want your lender to be able to raise rates until you’re stuck in debt forever.

So, based on these criteria, what are the poison loans that you should pay off first, or never get into in the first place?  Here are different types of debt listed from worst to best:

Poison Debt:

  1.  Payday loans:  Both have high interest rates and are generally for something that goes down in value.
  2. Credit cards:  Credit cards have high interest rates and often variable rates.  Plus, be late for a payment and you could see your interest rate go up to 35% or more.
  3. Margin Interest:  This is interest charged by a brokerage firm for buying securities beyond your means.  The danger here is that you may be forced to lock in a loss should your investments go against you.  Plus, the interest rates aren’t all that good.

Draining Debt:

  1. Car Loans:  If you need a loan to buy a car, it means that you are buying more car than you can afford.  Instead, save for a few months and buy a $3,000 car for cash from a private owner.  Drive that for a year or two, saving payments all of the time, then trade up for a $8,000 car.  Then, either continue to trade up or just be happy with $8,000 cars (they aren’t bad at all).
  2. Student Loans:  If you can get through college without student loans, do so.  The interest rates tend to be very low because they’re taxpayer subsidized, but it is better to start life with no debt so that you can get into a house and stop paying rent.  If you must take on student debt, take on as little as possible by graduating fast and then keep living like a student for a few years after college until you pay that debt off.
  3. Home Equity Loans:  Again, if you’re taking out a loan on your home, it means you’re buying things you can’t afford.  It is better to save up and pay cash if at all possible.  Plus, HELOCs can carry interest rates of 5-8%, so these will consume a good portion of your income.

“Good” Debt:

  1. Home Loan:  A home loan can be a good debt because it allows you to stop paying rent and leverage the value of an expensive asset, your home, to build wealth.  If you buy a $250,000 home, you’ll get to keep the appreciation on that home, which might be a real help when you’re ready to retire if you’re willing to downsize and/or move to a cheaper area.  Keep these loans at 15 years or less and make sure the rate is fixed.  Plus, keeping your mortgage payment below 25% of your take-home pay will make it a lot easier to make the payments.

Thanks to reader, Jessica, who suggested the topic for this post.  Keep them coming!

Your investing questions are wanted. Please send tovtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.