Thursday, July 16, 1998

Q. I was thinking that it might be prudent to borrow against our house and invest. Say we could borrow $100,000 and assume a 10 year mortgage at 7 percent. Were conservative investors, so say we invested the money in a Vanguard or T. Rowe Price couch potato fund or a balanced fund for the ten years.

My only concern is whether there would be enough of a difference, or spread, between the mortgage and the investment? It seems that in your columns youve put the return on these type of funds around 9 or 10 percent, max. If that is the case, then I dont know that 2 or 3 percent over 10 years is worth it. What are your thoughts?

—J.S., Dallas, TX

A. Its more complicated than that. When you take out a mortgage, you promise to make a series of equal payments to that the original debt will be repaid at the term of the loan. So you pay principal as well as interest. The shorter the term of the loan, the greater the amount of principal payment. If you divide the annual payments on a 30 year, 7 percent mortgage by the original debt you find that youll be returning 7.98 percent a year. Mortgage bankers call this figure the "constant." At 15 years youll be returning 10.78 percent a year. And at 10 years youll be returning 13.93 percent a year.

So what, you say, you will still only be paying 7 percent actual interest.

True. But your mortgage payment schedule is, in effect, a reverse dollar averaging commitment: you will always redeem more shares to make a monthly payment when the market is low than when it is high. This will work to reduce your effective rate of return. I think it is a formula for living a very powerless, anxious life. Or, as someone once said, "Long Tunnel, No Cheese."

Q. Your recent column on mutual fund taxes was very interesting. I have been aware of this problem for a long time, and 1997 cost me a lot more tax than prior years. What is the one best thing to look at in order to determine a fund's potential tax liability? What about these 'tax efficiency' ratings? Most importantly, what can one do about it? Does it help to sell prior to dividend date and then buy back in? From what you say, over the long term, tax managed funds don't help a lot because, sooner or later comes the tax bill. Is there such a thing as funds that go for long term gains as opposed to dividends and short term gains? —J.O.,

A. Spending a lot of time trying to avoid taxable dividends with an individual fund isn't a very fruitful activity, particularly if you face front or back-end loads.

That doesn't mean, however, that we should be fatalists and assume that the tax bill is inevitable. There are two important aspects to tax efficiency:

  • First, who has control over the creation of "taxable events"? It is one thing to pay taxes, it is another to have to pay them unexpectedly. In a tax managed fund— or a low turnover fund— the manager is investing long term and avoids taxable events. As a result, YOU have more control. Consequence? You can compound your investment growth, without much of a tax burden, and realize taxes in the distant future, over a long period of time.
  • Second, what kind of taxable events are happening? In a high turnover fund the manager is guaranteeing that you will pay early, and often, at ordinary income rates when you could be paying at lower capital gains tax rates. The difference can be significant. As I have pointed out in earlier columns, Vanguard Index 500 fund operates with such tax efficiency that it is highly competitive with tax deferred variable annuity accounts.

In the current market, equity funds deliver very little return in dividends. But some deliver a lot more short term capital gains than others. I think it is worthwhile to look for funds that are low turnover, tax managed, or both.

I am assuming, of course, that you are investing taxable money. If you are investing in your company 401k, an IRA, SEP, or Roth IRA, you dont have to worry about what your fund manager does.