Dividends, Interest & Appreciation

Knowledge is definitely power and whether we like it or not we're into the Geek Generation, dear reader, where we get information from so many sources that sometimes we overdose on it or get confused once we have it or even lose it and wonder where it went. On the TV show Married with Children actress Christina Applegate played the ditsy daughter who had the retention span of a turkey but one fine day studied to learn a plethora of stuff so she could appear on a television quiz show. The problem was that as she packed her short term memory with new stuff her long-term memory lost a bit of old stuff. It's like a gallon bucket full of water that you pour a teaspoonful more water into and you lose exactly that much.

We all get a bit of short-circuiting when we're mentally juggling several things at once. It's the old finding yourself in a room and wondering what I'm there for syndrome.

Amateur investors get caught up in an avalanche of material from allocation, sectors, technical investing and such that sometimes they get confused on the simple things such as the difference between dividends and interest. Here's a refresher to help understand how each works.

Interest is paid when you deposit money to someone or to something. For example a Certificate of Deposit is where you loan money to the bank in return for the use of your money the bank pays you a fee called interest. The bank guarantees the return of your money through an insurance policy, which we know as FDIC, and asset maturity date or the promise of liquidity. The important thing for you to remember is that when you loan money to a bank or credit union by buying a CD, money market or passbook, you do not own anything.

Bonds are another instrument where you are loaning money to a corporation, tax exempt entity or a government agency in return for interest. Corporations, tax exempt organizations and governments borrow money by issuing bonds. Bonds are nothing more than I-Owe-Yous with a minimum dollar amount, coupon and maturity. Some bonds are insured while most are not. Interest paid to bondholders vary depending on the credit worthiness of the entity issuing the bond. Bond people call that a coupon and you and I can call it interest because it means the same thing.

Dividends are something you get when a company pays shareholders a portion of the company's profits. It's important that you know the dividend comes from profits and it is not all the profits, just some of the profits. The board of directors of the company reviews how much money the company has earned, pays their bills, sets aside some money for a rainy day and with whatever is left declare a percentage of that money to pay to shareholders who own their stock.

Note: whenever a company pays a dividend shareholders will notice the common stock of the company reduces by the same amount. If the dividend is being used to buy additional shares of the stock the share price increase will equal exactly the amount of the dividend paid. And, why is that? Because profits are part of the stock value.

Currently dividends are taxed at a different rate than interest or bond coupons. See your tax advisor for the various ways dividends and interest are taxed along with capital gains.

Appreciation is when the company stock that has paid you a dividend increases in value from the price that you originally paid. Over time the company may increase its dividend and as the dividend increases this means the business must be doing well to support that increased dividend. Logically we can assume, and yes, in most cases, the common stock of the company also appreciates in value.

While not the same thing tax wise but a simple illustration on dividends and appreciation would be if you own a home free and clear and decide to rent it. Over time the value of your home should increase in value (appreciation) while the renter pays to live in your home and the amount of money you net after paying all expenses, taxes, insurance and upkeep on your home plus the deduction of depreciation, you can consider the income much like a dividend. This of course is not meant to assume a home is stock but an illustration on how some mutual funds and dividend paying stocks work.

The way you can keep it straight is if you receive interest you are a loaner and if you receive dividends you are an owner.

Hope this helped.

If you need information on anything in this blog call Paul Stanley @ 877 783 7080 or write to pstanley@westminsterfinancial.com. Send a friend to this address and I'll keep him informed as to news and updates.