As a financial coach, I spend a lot of time educating people and explaining concepts like “fixed income” and “equity ownership”. Today’s post is a great way to understand these two terms, which relate to bonds/savings and stock ownership.
When you go to the bank and deposit money into your savings account you are lending your money to the bank. They pay interest back to you as the loaner of the funds. Another option is to use your investment account to purchase an ownership share of the bank. In this case, you don’t get interest payments, but you get to share in any profits (or losses). Understanding the pros and cons of these two options will help you decide whether you want to be an owner or a loaner.
Pros of being a loaner
When you purchase bonds in your investment account you are essentially lending a company your money. That’s what bonds are – companies or government entities borrowing money then paying interest on the loan. This is why bonds are called “fixed income” because there is a set interest rate that the borrower agrees to pay.
Whether lending your money to your bank, the federal government, or to a company, there are some definite upsides.
1.Your return is going to be static
You don’t have to worry much about fluctuating markets or corporate returns. The interest payments you receive are agreed upon in advance when the company issues the bonds (or your bank sets the interest rate).
Right now our savings account pays us 1.15% interest. One of the more common bond ETFs (BND) is currently paying out 2.39%.
Sure, there might be some fluctuations over time but these are generally slow and moderate changes so you can bank on (no pun intended) getting pretty close to that rate. When rates do adjust you can see it coming a mile away and they’re small incremental changes.
2.Your money is (fairly) protected
As a loaner, there is a legal obligation for you to get paid back as a top priority. Just like if someone declared bankruptcy and all of their assets were sold to pay off their debt – the same would happen in a bond holder situation. The only way you would lose money is if the borrower had serious financial problems.
Since most bond funds are diversified the same as stock funds, the chance of enough defaults to make you lose all of your money are almost non-existent. Lending is a pretty safe way to get a return on your money.
Cons of being a loaner
1.Minimal return on your money
Investments of any type always have a risk versus reward component. The safer the investment, the lower the return. The borrower doesn’t have to pay a lot since the investment is low risk.
Because of this, the returns tend to be really low. Does the 1.15% or even 2.39% I mentioned above excite you? Maybe it does. If I remind you that inflation tends to run between 2-3% annually, does that change your thinking at all?
Considering inflation, savings accounts are destroying value right now. Bond funds are providing a little bit of an after-inflation return, but not much.
But it’s safe.
Do you like paying taxes? No, me either.
When you get interest from your bank you need to declare it on your personal income tax filings as income. It’s the same situation with most bonds.
So if you are in the 25% federal tax bracket, that 2.39% winds up looking like 1.79% after taxes. Oh, wait, that’s just federal taxes. Consider a state income tax of 5% (some states are WAY higher), then your after-tax return lands around 1.67%.
Not so great of a return on your money.
Pros of being an owner
The owner of a company – which is anyone who owns shares of stock issued by a business, is in a very different situation. Your potential returns aren’t set nor protected. But still there are strong benefits to consider.
You can start being an owner today by grabbing your free stock through Robinhood.
Companies aren’t required to pay out a portion of profits as dividends, but many do. When they do, you – as a shareholder and part owner of the business – get to share in those profits.
Consider the 500 companies that are in the S&P 500 Index right now. When you take them as a whole, they are currently paying out 1.91% annually to shareholders.
While that is definitely not guaranteed money, it’s almost as much as the income being paid out by bond funds right now.
2.Owners pay lower taxes on profits
Since corporations pay income taxes on their profits BEFORE paying out dividends, the money has already been taxed. That doesn’t keep the government from taxing it again (yes, it’s called double-taxation) but at least the second tax to owners is a lower rate.
Using the example from above, if you are in the 25% income tax bracket you only pay a 15% tax rate on qualified dividends. So that 1.91% after taxes looks like 1.62%. (Pretty tight there with prevailing bond rates – but again, it isn’t guaranteed.)
Businesses always keep a certain amount of their profits to invest back into their business. A well-run business will continue to grow in size over time. By “size” I mean revenue of course, but also products-sold, customers-served, etc. Good companies that do well should grow.
Let’s say a company which you own – even if only a single share- increases in size 50% over a five-year period. (Is that reasonable? While it is a faster growth rate than average, it’s exactly what Apple has done over the past five years.) As an owner of that company, your share value has likely increased similarly.
So not only do you get to share in profits via dividends but when you sell your shares in the future you get to benefit from any increase in the value of the company.
4.Owners pay lower taxes on growth
A neat thing many people don’t think about is that owners’ gains grow tax-free. Yes, the corporation pays taxes, but the shareholders of a business don’t pay taxes until they sell. Most people focus on the tax benefits of 401k and IRA plans but even taxable investment accounts have tax-deferred gains. (By the way, are you curious how much you’ll have if you max out your 401k plan?)
When you do decide to sell your ownership of a company – as long as you’ve held it at least one year – it is considered a long-term capital gain. Those gains are taxed the same as qualified dividends, so 15% federal taxes in the example I’ve been using.
And yes, it is fair because remember, taxes were already paid each year by the business as they report profit on their annual returns.
5.Owners have huge return potential
The average annual return of the S&P 500 Index is right around 10% when you include dividends.
When comparing that tax-advantaged 10% return to a heavily taxed 2.39%, well, it’s a huge difference. You’re looking at 5X the growth of your money. Let’s say you put $1,000 in bonds and the same amount in an S&P 500 index for twenty years. You’re potentially looking at comparing $1,491 worth of bonds to $7,328 worth of stocks.
Investing in stocks is one of the key factors behind how slow and steady got me to $500k.
Cons of being an owner
I would be negligent if I didn’t discuss some of the drawbacks of being an owner. It’s not all sunshine and roses.
1.NOTHING is guaranteed
I can’t say it enough, so I’ll say it again. As an owner, nothing is guaranteed. You’ll probably share in profits through dividends, but you might not. The company will probably increase in value over time, but it might not. The company will probably “live” a nice long life, but it might not. Companies can and do run into financial troubles – some even fail.
But that’s also why it’s always recommended to have a diversified portfolio. When you own shares in 500 different companies, the impact from a couple of them not doing well is often offset by the rest of the group.
2.That’s pretty much it
I’m having a hard time thinking of a good second con honestly. The risk and unknown is pretty much the main drawback of being an owner.
Do you want to own or loan?
There isn’t a right or wrong answer to this question. People with lower risk tolerances might be better off as loaners. People with a higher risk tolerance may be better off as owners.
More likely your investment portfolio will have you as both an owner AND a loaner. Your financial advisor will probably recommend some mix of stocks and bonds. Boring bonds to give some stability and exciting stocks to provide reasonable growth.
This was a guest post written by Brad Kingsley over at Maximize Your Money.