Apr
11
2023
woman doing taxes in kitchen

Is Automated Tax-Loss Harvesting a Good Idea?

By | Growing Wealth, invest, Investing | Comments Off on Is Automated Tax-Loss Harvesting a Good Idea?

Automated tax-loss harvesting can be a tool for tax-efficient investing because it involves using an algorithm to sell securities at a loss so as to offset capital gains and potentially lower an investor’s tax bill.

Standard tax-loss harvesting uses the same principle, but the process is complicated and an advisor might only harvest losses once or twice a year versus automated tax-loss harvesting which can be done more frequently.

That said, automated tax-loss harvesting — which is sometimes a feature of robo-advisor accounts — may give investors only limited (or possibly no) tax benefits. Here’s a breakdown of whether an automated tax-loss strategy makes sense.

Tax-Loss Harvesting: The Basics

First, a quick recap of how standard tax-loss harvesting works. Tax-loss harvesting is a way of selling securities at a loss, and then “harvesting” that loss to offset capital gains or other taxable income, thereby reducing federal tax owed.

The reason to consider this strategy is that capital gains are taxed at two different federal tax rates: long-term (when you’ve held an asset for a year or more) and short-term (when you’ve held an asset for under a year).

•   Long-term capital gains are taxed at 0%, 15%, or 20%, depending on the investor’s tax bracket.

•   Short-term capital gains are taxed at a typically higher rate based on the investor’s ordinary income tax rate.

The one-year mark is crucial, because the IRS taxes short-term investments at the higher marginal income tax rate of the investor. For high-income earners that can be 37% plus a 3.8% net investment income tax (NIIT). That means the taxes on those quick gains can be as much as 40.8% — and that’s before state and local taxes are factored in.

Example of Basic Tax-Loss Harvesting

For example, consider an investor in the highest tax bracket who sells security ABC after a year, and realizes a long-term capital gain of $10,000. They would owe 20%, or $2,000.

But if the investor sells XYZ security and harvests a loss of $3,000, that can be applied to the gain from security ABC. So their net capital gain will be $7,000 ($10,000 – $3,000). This means that they would owe $1,400 in capital gains tax.

The differences can be even greater when investors can harvest short-term losses to offset short-term gains, because these are typically taxed at a higher rate. In this case, using the losses to offset the gains can make a big difference in terms of taxes owed.

According to IRS rules, short-term or long-term losses must be used first to offset gains of the same type, unless the losses exceed the gains from the same type. When losses exceed gains, up to $3,000 per year can be used to offset ordinary income or carried over to the following year.

What Is Automated Tax-Loss Harvesting?

Until the advent of robo-advisor services some 15 years ago, tax-loss harvesting was typically carried out by qualified financial advisors or tax professionals in taxable accounts. But as robo-advisors and their automated portfolios became more widely accepted, many of these services began to offer automated tax-loss harvesting as well, though the strategy was executed by a computer program.

Just as the algorithm that underlies an automated portfolio can perform certain basic functions like asset allocation and portfolio rebalancing, some automated programs can execute a tax-loss harvesting strategy as well. SoFi’s automated platform does not offer automated tax-loss harvesting, but others may, for example.

So whereas tax-loss harvesting once made sense only for higher-net-worth investors owing to the complexity of the task, automation has enabled some retail investors to reap the benefits of tax-loss harvesting as well. The idea has been that automated tax-loss harvesting can be conducted more often and with less room for error, thanks to the precision of the underlying algorithm — which can also take into account the effects of the wash-sale rule.

The Wash-Sale Rule

It’s important that investors understand the “wash-sale rule” as it applies to tax-loss harvesting.

What Is the Wash-Sale Rule?

The wash-sale rule prevents investors from selling a security at a loss and buying back the same security, or one that is “substantially identical”, within 30 days. If you sell a security in order to harvest a loss and then replace it with the same or a substantially similar security, the IRS will disallow the loss — and you won’t reap the desired tax benefit.

In the example above, the investor who sells security XYZ in order to apply the loss to the gain from selling security ABC may then want to replace security XYZ because it gives them exposure to a certain market sector. While the investor can’t turn around and buy XYZ again until 30 days have passed, they could buy a similar, but not substantially identical security, to maintain that exposure.

That said, it can be tricky to follow this guidance because the IRS hasn’t established a precise definition of what a “substantially identical security” is. This is another reason why automated tax-loss harvesting may be more efficient: It may be simpler for a computer algorithm to make these choices based on preset parameters.

How ETFs Help With the Wash-Sale Rule

This is how the proliferation of exchange-traded funds (ETFs) has benefited the strategy of tax-loss harvesting. Exchange-traded funds, or ETFs, are baskets of securities that typically track an index of stocks, bonds, commodities or other assets, similar to a mutual fund. Unlike mutual funds, though, ETFs trade on exchanges like stocks.

In some ways, ETFs may make tax-loss harvesting a little easier. For instance, if an investor harvests a loss from an emerging-market stocks ETF, he or she can soon after buy a “similar” but non-identical emerging-market stocks ETF because the fund may have slightly different constituents.

Because most robo-advisors generate automated portfolios comprised of low-cost ETFs, this can also support the process of automated tax-loss harvesting.

Other Important Tax Rules to Know

Tax losses don’t expire. So an investor can apply a portion of losses to offset profits or income in one year and then “save” the remaining losses to offset in another tax year. Investors tend to practice tax-loss harvesting at the end of a calendar year, but it can really be done all year.

As noted above, another potential perk from tax-loss harvesting is that if the losses from an investment exceed any taxable profits from trades, the losses can actually be used to offset up to $3,000 of ordinary income per year.

How Much Does Automated Tax-Loss Harvesting Save?

It’s hard to say whether automated tax-loss harvesting definitively and consistently delivers a reduced tax bill to investors. A myriad of variables — such as the fluctuating nature of both federal tax rates and market price moves — make it difficult to calculate precise figures.

The Upside of Automated Tax-Loss Harvesting

One study of standard (not automated) tax-loss harvesting that was published by the CFA Institute in 2020 found that from 1926 to 2018, a simulated tax-loss harvesting strategy delivered an average annual outperformance of 1.08% versus a passive buy-and-hold portfolio.

Taking into account transaction costs and the wash-sale rule, the outperformance or “alpha” fell to 0.95%.

The study found the strategy did better when the stock market was volatile, such as between 1926 and 1949, a period which includes the Great Depression. The average outperformance was 2.13% a year during that period, as investors found more opportunities to harvest losses. Meanwhile, between 1949 and 1972 — a quieter period in the market as the U.S. underwent economic expansion after World War II — tax-loss harvesting only delivered an alpha of 0.51%.

The Downside of Automated Tax-Loss Harvesting

While the research cited above identifies some benefits of tax-loss harvesting, like many investment studies it’s based on historical data and simulations of a portfolio, not real-world investments.

Another fact to bear in mind: This study does not factor in the impact of automated tax-loss harvesting, which is typically conducted more frequently — and may not deliver a tax benefit.

Indeed, in 2018 the Securities and Exchange Commission (SEC) charged a robo-advisor for making misleading claims about the benefits of automated tax-loss harvesting in terms of higher portfolio returns. Investors should know that there could be no or little tax savings, or even a bigger tax bill, depending on how different securities perform after they’re sold (or bought back).

For instance, if the underlying algorithm that automates trades in a robo portfolio harvests a loss from one ETF (to offset the gains from a sale of another ETF), it might then purchase a replacement ETF that’s not substantially identical, per the wash-sale rule.

If the second ETF is sold later, the gains realized from this second sale could be so high that they cancel out or be greater than the tax benefits from selling the first fund to harvest the loss.

In that case, the investor could end up paying more taxes down the road — effectively deferring, not eliminating, the tax burden.

Continuously trading assets in automated tax-loss harvesting also means an investor may incur additional costs, such as more transaction fees.

Pros of Automated Tax-Loss Harvesting

1.    Standard tax-loss harvesting is complex and time-consuming, but the benefits are well established. Therefore using automated tax-loss harvesting may be an efficient way to reap the benefits of this strategy because it can be done more automatically and consistently.

2.    To realize the benefits of tax-loss harvesting investors must obey the IRS wash-sale rule, which imposes restrictions that can be tricky to follow. In this way, an automated strategy may limit the potential for human error and may increase the tax benefits for investors.

Cons of Automated Tax-Loss Harvesting

1.    Because an algorithm performs tax-loss harvesting on an automated cadence, investors cannot choose which investments to sell and when and therefore have less control.

2.    An automated tax-loss program may not be able to anticipate a security’s future gains that could reduce or eliminate the tax benefit of harvested losses.

3.    Automated tax-loss harvesting could increase the amount an investor pays in transaction fees, which can lower portfolio returns.

The Takeaway

Automated tax-loss harvesting is a feature primarily offered by robo-advisors, which use a computer algorithm to automatically sell securities at a loss in order to potentially reduce the tax impact of capital gains realized from the sale of other securities.

While this practice can offer tax benefits in some cases, and academic studies have used portfolio simulations to gauge the potential for outperformance, it’s unclear whether automated tax-loss harvesting offers the same benefits. Because the strategy is carried out by an underlying algorithm, a computer program may not be capable of making more nuanced choices about which assets to sell and when.

Investors could potentially end up still owing capital gains taxes or paying more in transaction fees and brokerage fees.

If you’re ready to start investing, it’s easy to open an Active Invest account with SoFi Invest® and start trading stocks or set up an automated portfolio. SoFi’s automated portfolio does not offer tax loss harvesting. SoFi members have access to complimentary advice from a financial professional. Set up your portfolio today!

See why SoFi is this year’s top-ranked robo advisor.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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Apr
11
2023
woman at pharmacy

Investing in the Pharmaceutical Industry

By | Growing Wealth, invest, Investing | Comments Off on Investing in the Pharmaceutical Industry

The pharmaceutical industry, with nearly $1.5 trillion in global sales a year, offers many opportunities for investors. Some pharma stocks provide dividends, while others have potential for significant growth. Beyond these potential upsides, investing in pharmaceuticals also helps expand health care for people around the world.

But as with any industry, pharmaceutical stocks have risks, and investors would be wise to research each company before they buy stock. Here’s some key information about the industry and ways to find pharmaceutical stocks for interested investors.

An Intro to the Pharmaceutical Industry

Pharmaceutical companies research, develop, make, and sell medications, including preventive medicines, treatments, and vaccines. Two segments of therapeutics make up the industry: pharmaceuticals and biologics. It’s also important to know the difference between pharmaceutical stocks and biotech stocks.

Pharmaceutical drugs are tablets or pills made out of synthetic or plant-based chemicals. Because they are small and fairly easy to make, companies can produce hundreds of thousands of them. When drugs are first approved, they generally have a patent or market exclusivity, meaning that only the pharma company that developed them can manufacture and sell the drugs.

Once the patent or exclusivity ends, other companies can create generic forms of the drug and begin to compete with the pharma company. The generic drugs are chemical copies of the original drug but sell at lower prices, making it hard for the original pharma company to compete. This can lead to its stock losing value.

Meanwhile, biologics are products such as vaccines, gene therapies, and medications for blood disorders that are large, protein-based molecules made out of living cells. Biologics are more complex to manufacture, which is one reason they’re more expensive.

They also have tighter restrictions on distribution than pharmaceuticals do. These factors make it more challenging for companies to enter this space and for competitors to succeed. If competitors do create a similar product, it is called a biosimilar. Unlike generics, biosimilars aren’t interchangeable, so biologics don’t have the same stock drop-off that pharmaceuticals do.

It takes about 10 years and an average of $1.3 billion to $2.8 billion to bring a new drug to market, but in special circumstances, the FDA can expedite approval.

Why Invest in Pharmaceuticals?

With pharmaceuticals, whether investors are looking for high growth potential, long-term value, or stable dividends, they can find a pharma stock that will fit the bill. There are hundreds of early-stage and established stocks, mutual funds, and exchange-traded funds out there.

About 10,000 Americans turn 65 every day, according to the AARP. And by 2030, the country will have more residents 65 and older than children, the Census Bureau has projected.

This means more people needing health care and pharmaceutical drugs, which in turn is expected to make pharma stocks grow. U.S. health spending is projected to reach nearly $6.8 trillion by 2030, according to the Centers for Medicare & Medicaid Services.

Pharmaceutical stocks don’t always follow the same trends as other stocks because people need medications no matter what is going on in the market. This doesn’t mean that pharma stocks always perform better than the broader market, but sometimes they don’t follow the same lines. Certain pharmaceutical exchange-traded funds (ETFs) have historically performed quite a bit better than the S&P 500 Index.

The health care sector can perform well during tough economic times, since people always need health care no matter what is going on in the world. About 49% of people in the U.S. report having used at least one prescription drug in the past 30 days, with 24% using three or more, according to the Centers for Disease Control and Prevention.

This translates to the companies that make those drugs consistently earning revenue even when the rest of the stock market is down. Larger companies have fairly consistent income streams, while smaller companies that show promise get funding from investors and sometimes get acquired by larger companies.

A few other reasons pharmaceutical stocks look promising as a long-term investment are:

•   People are living longer, and the majority of elderly Americans take prescription medications. The longer people live, the more years they will be paying for those drugs.

•   The health care sector is expanding in countries outside the United States.

•   The government has been spending more on health care research.

•   New types of therapies, such as gene therapy, are getting more sophisticated. Some of these are very expensive.

How to Choose Pharmaceutical Stocks

With so much potential in pharma, it can be difficult to navigate the hype and figure out what’s really a good investment. Billions of dollars are invested in medical research and drugs each year. But not every company becomes a success.

As with any stocks, investors will want to research pharma stocks before buying. Here are a few key factors to look at when evaluating stocks.

Growth Prospects

By looking at a company’s earnings and revenue, one can see how much it’s been growing and whether growth is slowing down. Investors can also look into each company’s pipeline to see how close to market a drug being developed is.

Pharma companies have to go through certain steps to develop, test, and get drugs approved. They often make pipelines available to the public, so investors can see which drugs are in the early stages of development, preclinical testing, going through clinical trials in humans, or getting FDA approval or other necessary regulatory approvals.

Drugs may get approval for treatment of certain diseases or for specific demographics, but the makers can then apply for approval for additional uses. If they get the expanded approval, this can lead to growth for the company.

Knowing when to buy stocks is challenging, and trying to time the market generally isn’t a good strategy. That said, investors can follow different pharmaceutical companies to see when they have the potential to grow and become successful. If a pharma company has patents that are close to expiring, for instance, this may slow down growth, as competitors can create generic forms of the same drugs.

The process companies go through to develop and bring drugs to market is generally as follows:

•   Drug discovery: During this phase, drugs and the diseases they can potentially treat are discovered.

•   Preclinical trials: Potential drugs get tested in test tubes or on live animals.

•   Clinical trials: Small human trials determine a safe dosage and how humans react to it. Then, groups of 100 or more people test the drug to discover short-term side effects and optimal dosage. Finally, groups of hundreds or thousands of people test the drug to determine efficacy and safety. When drugs reach the clinical trial stage, this could be a good time for investors to keep an eye on them. If a drug makes it through trials, the company has potential for significant growth. But if the drug fails during testing, the stock is unlikely to do well.

•   Regulatory approval: In the United States, the Food and Drug Administration’s Center for Drug Evaluation and Research assesses and approves new drugs, and in the EU, approval is completed by the European Medicines Agency. If the benefits of the drug outweigh the side effects and risks, and the drug is a good alternative or additional treatment for the disease it is targeting, these agencies will consider approving the drug.

Types of FDA Application

There are different types of pharmaceutical FDA applications, some of which give companies more potential for stock growth than others. The application types are:

•   Investigational new drug application: This is the first application step that companies must go through.

•   New drug application: This is an application to market and sell a new drug. Companies filing this application have the most potential for stock growth because they are introducing a new product to market.

•   Abbreviated new drug application: Companies developing a generic form of an existing drug go through this application.

•   Therapeutic biologics application: This is required under the PHS Act for biologics.

•   Over-the-counter drug application: This is for companies looking to sell over-the-counter drugs, which are categorized as being safe to distribute without a prescription.

Dividends

Not all pharmaceutical companies pay dividends, but some of them do provide consistent payouts to investors. The dividends can add up.

Qualitative and Quantitative Metrics

The same rules apply to pharmaceutical stocks as to any other stock when it comes to evaluation. Investors should look at a company’s valuation, revenues, growth, leadership team, product pipeline, and other key metrics to decide whether to invest. Stock valuation ratios, such as price-to-earnings ratio and price-to-earnings-growth ratio, are very useful when comparing different stocks within the same industry.

However, some pharmaceutical companies are not yet profitable if they are in the drug development and trial phases. In this case, investors can look at the rate of cash burn: how much money the company is spending each quarter to develop a drug. It’s very expensive to develop a drug, so if a company is burning through cash and doesn’t have much left to work with, this might not bode well for the stock.

Another useful metric to look at is the price-to-sales ratio. This compares a company’s sales to the price of its stock. If the company doesn’t have sales yet, investors can make predictions about what those sales figures might look like.

Trends and Developments

Over time, trends in the types of diseases being targeted and the types of therapies being developed change. Investors can look into stocks in popular areas of treatment to find stocks with growth potential.

For instance, many drugs are in development to treat breast cancer and non-small-cell lung cancer. Treatments that are bringing in significant revenue globally include oncologics, antidiabetics, respiratory therapies, and autoimmune disease drugs. Additional lucrative treatment areas include antibiotics, anticoagulants, pain, and mental health.

Risks of Investing in Pharmaceutical Stocks

As with any type of investment, pharma stocks come with some risks. Some of the main risks to be aware of are:

•   Clinical failure: Many drugs don’t make it through the phases of clinical trials. If a drug has made it to the final stage, it’s more likely to succeed, but even at this phase, drugs can fail.

•   Inability to obtain approval: Just because a drug does well in trials doesn’t mean it will be approved by regulatory agencies.

•   Difficulties getting reimbursement and pricing drugs: Health insurance companies, government programs, or individuals must cover the cost of drugs, and companies aren’t always able to secure the money they need. Sometimes, companies are pressured to lower the price of drugs to make them more accessible, and this can result in financial struggles for the company.

•   Industry competition: As mentioned, when patents run out, pharma companies can struggle to keep up with competitors that develop cheaper generic versions of drugs. In addition, during the drug development phase, it’s not uncommon for multiple companies to be working on medications to treat the same illness. If one company can make it to trials or get approval first, this can put them way ahead of the competition, especially if it results in patent exclusivity.

•   Litigation and liability: In the pharmaceutical industry, lawsuits are common. Drugs can also be recalled from the market if they’re found to be unsafe.

Investing in Pharmaceutical Stocks

If you’re looking to start investing in the pharmaceutical industry, you might consider buying pharmaceutical ETFs. Or, you could do your due diligence and choose individual stocks, aiming for stable dividends or growth potential. Before investing, it helps to familiarize yourself with the pharmaceutical industry to better understand how to choose pharma investments, and also ensure you understand the potential risks of investing in pharmaceutical stocks.

Online platforms are a great tool to use if you’re investing in ETFs and other stocks, whether in the pharmaceutical industry or elsewhere. SoFi Invest®, for instance, offers a suite of tools to track specific stocks, select individual stocks, trade fractions of stocks, or purchase ETFs.

Invest with as little as $5 with a SoFi Active Investing account.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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Apr
11
2023
x Steps for Balancing a Checkbook

4 Steps for Balancing a Checkbook

By | Budgeting & Goals, Financial Independence, money | Comments Off on 4 Steps for Balancing a Checkbook

Admittedly, checks and checkbooks aren’t as popular as they were in the past, when they were a standard way to pay for life’s daily expenses. But that doesn’t mean that balancing a checkbook isn’t still a valuable skill and an important way to keep your budget in good shape.

It’s a smart idea to keep tabs on how much is coming into your checking account and how much is going out. This helps you avoid bouncing checks (and paying those steep overdraft fees), spot errors and fraud attempts, and know how well you are doing in terms of spending.

Many people shy away from balancing (aka reconciling) their checking account because it seems as if it’s a time-consuming task and may require high-level math skills. Not true!

Once you learn the four steps of balancing your checkbook, it is a simple task that can be accomplished in a few minutes once every week or so. Read on to learn:

•   What does balancing a checkbook mean?

•   How do you balance a checkbook?

•   What is the first step in balancing a checkbook?

•   What are the benefits of balancing a checkbook?

What Does Balancing a Checkbook Mean?

The task of balancing a checkbook actually doesn’t have anything to do with the checkbook itself (the stack of checks you may write to pay for goods and services), although your checkbook register is still a great tool for doing the job.

Rather, balancing a checkbook refers to the process of reconciling and cross-checking the many transactions that occur in your checking account.

To summarize the process of balancing your checkbook: This involves recording all of your deposits and withdrawals on a regular basis, adding and subtracting them as you go, and then comparing your numbers to the bank’s to make sure they agree.

Benefits of Balancing Your Checkbook?

Balancing your checkbook, whether with personal vs. business checks, comes with a number of key benefits. These Include:

Knowing Your Balance in Real Time

When you log every transaction, you add to your balance if it’s a deposit or subtract if you’re paying a bill. In this way, you are able to know the true balance of your account, which may not yet be reflected online or in your app.

That’s because when you write a check against your account, the bank won’t deduct those funds from your account until the person you gave the check to deposits it.

Your bank app may show you have $2,000 in your account but if you wrote a $1,000 check yesterday, you actually only have $1,000 available to spend.

Tracking Your Spending and Sticking with Your Budget

During the balancing process, you look at every transaction in your checking account for a period of time, whether it’s a day, a week, or a month.

You might find that you’re spending more than you thought or taking out more cash from the ATM each month than your current budget allows.

Balancing your checkbook on a regular basis can help you monitor your spending, and help to ensure you’re able to maintain your savings goals.

Reviewing Your Account for Errors, Fraud, or Billing Changes

Regular reviewing and tracking of your account’s expenditures can help you immediately spot any purchases or transfers of money that you don’t recognize.

You may also pick up on fees your bank is charging that you weren’t aware of or that are new.

Or, you might notice that one of your auto-pay bills has gone up in price. If your payments are processed automatically without your review, those increases could go unnoticed and unaddressed for months, disrupting your cash flow and possibly causing other financial issues down the line.

Recommended: Can I Use Checks With an Old Address?

Are There Reasons Not to Balance Your Checkbook?

You don’t need to balance your checkbook if you are using and are satisfied with another method to keep tabs on your spending. For instance, if your bank offers an app that works well for you, fine. Or perhaps you are in the habit of monitoring your checking account regularly and feel comfortable with that process.

As noted above, however, there can be a lag time between when you write a check or even swipe a debit card and when the charge is actually debited. This may lead you to believe you have more money on deposit than you truly do. That may motivate you to balance your checkbook instead.

How to Balance a Checkbook in 4 Steps

Here’s an easy step-by-step approach to balancing your checkbook.

1. Recording Your Current Balance

Here’s the first step toward reconciling your checkbook register: logging your bank account balance.

•   You can quickly find your checking account balance by going on your bank’s website or using its mobile app.

•   If you’re using a paper checkbook register, you can then record this number in the top spot above the spaces you use to log your transactions.

•   If you don’t have a register or prefer to go digital, you can create your own register on your computer, or use an open source spreadsheet platform, such as Google Sheets. An online spreadsheet has the advantage of being accessible anytime from any device.

That’s it for the first step in balancing your checkbook.

2. Recording Any Pending Transactions

The next step in balancing your checkbook involves recording transactions that haven’t fully processed yet.

•   Account for any pending transactions. These are transactions that you know are coming, but have not yet cleared. For example, when you deposit a check (whether at a bank, ATM, or mobile deposit), your bank might release only part of the funds immediately, placing a hold on the rest of the money until the check clears.

Similarly, when you pay for something with your debit card or a check, the transaction may take a day or two to go through.

•   You can write down the date of the transaction and a brief description and, if it’s a check, the check number.

•   Do the math next: Starting with the first transaction you enter, subtract the amount from your available balance, or, in the case of a deposit, add it to the balance.

•   Then record the new amount on the next line of your register. You can continue doing this until all transactions are reconciled. The final number is (ta-da) your current available balance: the actual amount you have in the account to spend.

3. Continuing to Record Transactions

Next, you can log transactions as they happen or at regular intervals.

•   As you continue to make transactions, you can then record them in your register or spreadsheet so you have a running tally of your debits, credits, and current balance. You’ll want to account for both checks, debit card usage, and deposits to the account.

You can do this as you go, or you can collect your receipts and record them in your checking register or spreadsheet at the end of the day or week.

Recommended: Differences Between Current Balance and Available Balance

4. Comparing Your Numbers

Now it may be time for a little bit of cross-checking detective work:

•   Once or twice a month, it’s a good idea to log on to your account and compare your bank’s total withdrawals and deposits and balances with your own records. If they match, you’re in good shape; you have a balanced checkbook.

If the numbers don’t align, you may then want to go back through your records, as well as the bank’s transaction history, to see where the discrepancy lies.

You may find that you forgot to record a transaction or you wrote down a number incorrectly, or made a simple math error. Or perhaps you forgot to account for account fees or a miscellaneous charge that was deducted.

Or you might pick up an error on the bank’s part, a change in the amount a vendor is billing you, or a potentially fraudulent charge. Generally, the quicker you pick up and address any discrepancies the better, particularly in the case of bank fraud or identity theft.

What Is a Check Register?

A check register is a compact booklet that acts as a kind of spreadsheet, helping you record transactions and tally your checking account’s balance.

These typically come when you order checks, or you can buy them at some retailers or online vendors.

Check registers can be a valuable tool in balancing your checkbook and staying on budget.

Is Knowing How to Balance a Checkbook Now Obsolete?

Knowing how to balance a checkbook may be less vital than it was in the past, but it is still an important skill for tracking incoming funds, outgoing payments, and your total amount of money on deposit.

If you don’t like the paper and pencil aspect of balancing a checkbook, you can use apps and digital tools to keep tabs on your funds.

Digitally Balancing a Checkbook

If you are the type of person who doesn’t like writing down numbers and calculating your available balance on paper, you can use digital tools to help the process along.

There are apps that promise to help you balance your checkbook, but some involve a fair amount of data entry. Your financial institution may offer tools (online and in an app) to help you check your balance, see charges, view pending transactions, and more. For many people, these can be a way to keep tabs on their account balance.

Opening Checking and Savings SoFi Accounts

Even in an increasingly paperless world, it can still be important to balance your checkbook.

Regularly balancing your checking account can give you a clear sense of not only how much money is in your bank account, but where your money goes.

This can help you track your spending, avoid bouncing checks, detect billing changes, and also spot errors or even fraudulent charges as soon as they happen.

If you’re looking for an easy way to keep tabs on your money, you may want to sign up for a new bank account with SoFi.

With SoFi Checking and Savings, you can get all the numbers you need to track your finances at a glance and on the go using the SoFi app. Plus, you’ll earn a competitive annual percentage yield (APY) and pay no account fees, which can help you money grow faster.

See how easy it is to manage your finances with SoFi Checking and Savings today.

FAQ

Is balancing a checkbook still necessary?

While balancing your checkbook isn’t as common as it was before, it is still a valuable way to keep tabs on the money in your checking account, spot errors, and identify any suspicious activity. It is also a wise move if you are trying to stick with a budgeting method and avoid overdrafting your account.

How do you balance a checkbook that hasn’t been balanced before?

You can start balancing your checkbook at any time. View your balance online, and log it in your checkbook. Account for any pending transactions, and then, going forward, note deposits, withdrawals and other debits, plus any fees that are taken out of your funds.

How often should you balance your checkbook?

It can be wise to balance your checkbook in real time. That means, it can be smart to note any checks you write as you do so, and log debit card transactions as they happen so you don’t forget about them. For some people, though, this isn’t convenient, and they prefer to spend a few minutes reconciling their checkbook once or twice a week. The choice is yours.

SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2024 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.

SoFi members with direct deposit activity can earn 4.20% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a recurring deposit of regular income to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government benefit payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, or are non-recurring in nature (e.g., IRS tax refunds), do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate. SoFi members with direct deposit are eligible for other SoFi Plus benefits.

As an alternative to direct deposit, SoFi members with Qualifying Deposits can earn 4.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant. SoFi members with Qualifying Deposits are not eligible for other SoFi Plus benefits.

SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.20% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.

SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.

Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.

Interest rates are variable and subject to change at any time. These rates are current as of 10/31/2024. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

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What Is an Assumable Mortgage?

By | Home Ownership, mortgage | Comments Off on What Is an Assumable Mortgage?

Assuming a mortgage means that the buyer of a home is able to take over the seller’s existing mortgage. When mortgage assumption is possible, it may help a buyer score a lower interest rate and save money in other ways as well. In times when interest rates are headed upward, an assumable mortgage can be quite a windfall.

But, reality-check time: Mortgages are only assumable in certain situations, and there are pros and cons to consider. If you’re home shopping and want to consider this option, read on to learn more, including:

•   What is an assumable mortgage?

•   How do I know if a mortgage is assumable?

•   What are the benefits of an assumable home loan?

•   What are the downsides of an assumable mortgage?

What Is an Assumable Mortgage?

The meaning of an assumable mortgage is that the buyer, when purchasing a home, takes over the existing mortgage held by the seller. This means the buyer assumes responsibility for the loan’s outstanding balance, its interest rate, and making payments for the entire loan term.

This can be an appealing option if, say, the seller’s mortgage was taken out with a considerably lower interest rate than is currently available. In this scenario, the buyer could stand to save thousands over the life of the mortgage loan.

However, a buyer may also need to finance the amount of equity the seller has in the home.

It’s important to note that not all mortgages are assumable. For those that are, it’s recommended that all parties know in advance what obligations they have when they agree to a mortgage assumption, just as with any other financial agreement.

What Types of Loans Are Assumable?

Typically, home loans that operate outside the federal government’s mortgage loan environment, such as conventional 30-year mortgages issued by private lenders, are not assumable. (How do you know if a conventional mortgage is assumable? It will likely be an adjustable-rate loan, and the seller will have to check with their lender to be sure.)

Certain kinds of mortgages that are insured by the government and issued by private lenders are, however, assumable. A seller usually must obtain lender approval for the assumption, or in the case of USDA loans, agency approval. And the buyer must qualify. These loans include:

•   FHA loans: The Federal Housing Administration (FHA) insures these mortgages, which are popular with first-time homebuyers. With a minimum 3.5% down payment for borrowers with a credit score of 580 or higher, FHA mortgages are assumable.

•   VA loans: Home loans guaranteed by the Department of Veterans Affairs (VA) are also assumable, and — perhaps surprisingly — the buyer does not have to be a veteran or in the military. Note: The seller of these loans may remain responsible for the mortgage if the buyer defaults.

•   USDA loans: Loans guaranteed by the Department of Agriculture (USDA) are assumable only if the current owner is up to date on payments.

One last note about the options above: While assumable mortgages can be part of a wrap-around mortgage, they are not one and the same.

When a mortgage is assumed, the buyer pays the lender every month. With a wrap-around mortgage, which is a kind of owner-financing, the buyer pays the seller.

How to Get an Assumable Mortgage Loan

Here are some points to consider if you are contemplating assuming a mortgage:

•   First, confirm that the loan is assumable. For most conventional mortgages, assumption is not an option.

•   If assumption is possible, the homebuyer must apply for the assumable mortgage and be vetted for creditworthiness and the ability to meet all the contractual requirements. It’s vital that the buyer show that they have the financial assets needed to qualify for the loan.

•   Recognize that the buyer will need to make up any difference between the amount owed and the home’s current value. This means that if the seller of a $300,000 home has a $100,000 mortgage that’s assumable, the buyer would need to be able to put down $200,000 to assume that loan. Obviously, this scenario could present a significant financial hurdle for many prospective homebuyers.

•   If the mortgage lender or agency signs off on the deal, the property title goes to the homebuyer, who starts making monthly mortgage payments to the lender.

•   If the lender denies the application, the home seller must move on, and the buyer would likely resume shopping elsewhere.

Recommended: How to Buy a Multi-Family Property

Why Do Assumable Mortgages Exist?

Actually landing an assumable debt can be beneficial for both a buyer and seller, but the mortgage lending industry may not make it easy to cut a deal. Why? Because as history attests, mortgage lenders may lose money on assumable mortgages.

In the late 1970s and early 1980s, when interest rates were at the highest levels in modern history, assumable mortgage deals were attractive to buyers who could take over a seller’s mortgage at the original loan interest rate. In many cases, this would yield a bargain vs. the then-current rate for a new mortgage. (How high did rates go? In October 1981, 30-year fixed-rate mortgages hit an eye-watering peak of 18.45%.)

Mortgage companies, however, could see that they would lose money if home buyers chose a lower-rate assumable loan over a higher-rate new mortgage loan. That’s one reason mortgage companies began inserting “due on sale” clauses, which mandated full repayment of the loan for most home transactions.

As the FHA and VA began issuing more mortgage loans to homebuyers, they offered more relaxed rules allowing assumption transactions. Mortgages could transfer to the homebuyer as long as they demonstrated the ability to repay the remaining home loan balance, usually after a thorough credit check.

How Do Assumable Mortgages Work?

With an assumable mortgage, the buyer will become the holder of the mortgage originally taken out by the seller. The buyer, as mentioned above, may have to clear certain qualification hurdles to do so.

It’s also important to note that, as briefly mentioned above, the homebuyer must make up any difference between the amount owed on the mortgage and the property’s current value. That could mean the buyer pays cash to make up the difference or takes out a second mortgage.

An example: Say a house is valued at $350,000, and the home seller has a $225,000 balance on the home’s original mortgage. Under the terms of most assumable mortgage loans, the homebuyer would need to deliver $125,000 at closing to cover the difference between the original mortgage and the current estimated value of the home, usually determined by an appraisal.

Another important aspect of how assumable mortgage loans work are the two models possible: a simple mortgage assumption or a novation-based mortgage assumption.

Simple Assumption

In a typical simple mortgage assumption, the buyer and seller agree to engage in a private transaction.

•   This means that the mortgage lender is not necessarily aware of the transfer of the mortgage and therefore the new buyer does not go through the underwriting process with the lender.

•   The home seller usually just transfers the title of the property to the buyer after the buyer agrees to take over the remaining mortgage payments.

•   If the buyer misses monthly payments or defaults on the original mortgage loan, the lender could hold both parties responsible for the debt, and the credit scores of both buyer and seller could be significantly damaged if the debt isn’t repaid. In this scenario, an assumable mortgage home for sale could wind up being problematic for both parties.

Novation-Based Assumption

Unlike a simple mortgage assumption, where mortgage underwriting usually isn’t directly involved, an assumption with novation means the lender is involved.

•   The lender vets the buyer and agrees to the loan transfer.

•   This means the buyer agrees to assume total responsibility for the existing mortgage debt and remaining payments.

•   Under those terms, the original mortgage lender releases the home seller from liability for the remaining mortgage loan debt. The documentation, such as a deed of trust (if used), will be in the buyer’s name alone.

Pros and Cons of Assumable Mortgages

Assumable mortgage loans have upsides and downsides.

Upsides of an Assumable Mortgage

First, consider these pluses:

•   A lower rate may be possible. The buyer may save significant money on the loan if the original mortgage’s interest rate is lower than current rates.

•   Closing costs are curbed. The buyer might also benefit because closing costs are minimized in private home sale transactions between a buyer and a seller.

•   No appraisal is needed. With no need to get a new mortgage on the property, a home appraisal isn’t required for a mortgage assumption, which can save time and money. The buyer could request an appraisal as part of the general home purchase agreement, however.

Downsides of an Assumable Mortgage

Now, the minuses:

•   Upfront cash may be required. To meet the terms of an assumable mortgage, the buyer may need to have a substantial amount of upfront cash or take out a second mortgage to close the deal. This usually occurs when the property’s value is greater than the mortgage balance. The seller has perhaps built up considerable equity over the years.

•   Second mortgages can be problematic. Second mortgages aren’t always easy to obtain, as mortgage lenders may be reluctant to issue a second home loan when the original mortgage still has a balance due. And a second mortgage probably carries closing costs, meaning the seller needs to shell out more cash.

•   The property may be in distress. In some cases, the home seller may be eager to get out of a home that is proving to be too expensive for their budget. Simply put, they might be behind on payments. In that event, the mortgage lender may require the mortgage to be made current (meaning getting up to date on payments) before it will approve an assumable mortgage.

•   FHA loans carry an add-on. If the home seller put down less than 10% of the home’s cost when getting an FHA loan, there will be a mortgage insurance premium for the entire loan term. This would add to the buyer’s monthly costs.

Here’s how this intel stacks up in chart form:

Pros of Assuming a Mortgage

 Cons of Assuming a Mortgage
Possibility of a lower interest rate than market rate, saving money over the life of the loan Buyer must make up difference if home value exceeds mortgage balance
Reduced closing costs Home may be in distress
Home appraisal not necessary FHA loans usually carry mortgage insurance premium

Examples of Assumable Mortgages

If you’re hoping to find an assumable mortgage, it will most likely be a government-insured or -issued loan, as mentioned above; perhaps one offered as a first-time homebuyer program. Here’s a bit more about these mortgages and how a loan assumption would work:

•   Federal Housing Authority (FHA) loans: These government loans, which are insured by the FHA, may be assumable. Both parties involved in a mortgage assumption, however, must qualify in certain ways. For instance, the seller must have been living in the home as a primary residence for a period of time, and the buyer needs to be approved via the usual FHA loan application process.

•   Veterans Affairs (VA) loans: If a seller has a loan backed by the VA, it may indeed be assumable. A buyer who wants to take over the loan can apply for a VA loan assumption and doesn’t need to be a current or former member of the military service.

•   U.S. Department of Agriculture (USDA) loans: To assume a USDA loan on a rural property, a buyer will have to show an adequate income and credit to be approved by the USDA.

Recommended: Buying a Home with a Non-Spouse

Who Are Assumable Mortgages For?

Assuming a mortgage can be a good option for those who are property shopping in a time of rising interest rates and would like to take over the seller’s lower-rate loan. This can help save money, and it can also spare the buyer some of the time, energy, and money needed to apply for a new loan.

In addition, an assumable mortgage may work best for buyers with access to cash, as they will probably need to cover the difference between the mortgage amount and the value of the home they are buying.

Who Are Assumable Mortgages Not For?

Those purchasing a home that currently has a conventional mortgage will most likely not be able to take over that loan.

Additionally, if a mortgage is assumable, it’s important to recognize this scenario: If there’s a considerable gap between the mortgage amount and the property’s value, the buyer needs to bridge that. That means either ponying up a chunk of cash or finding a second mortgage, which may not be financially feasible for some prospective homebuyers.

The Takeaway

Assumable home loans are generally difficult to find and to close, and may require the buyer to take on the onerous task of qualifying for a second mortgage. But if the buyer finds that assuming the mortgage will save money over getting a new mortgage (primarily through a lower rate), an assumable mortgage could be a good way to go.

Hunting for a mortgage? SoFi offers home mortgage loans with as little as 3% down for first-time homebuyers, and getting prequalified is quick and easy.

SoFi Mortgage Loans: Fast and flexible.

FAQ

Is it a good idea to assume a mortgage?

Assuming a mortgage can have benefits. If you find an assumable mortgage home for sale, you might be able to take over the seller’s mortgage at a lower rate than what’s currently offered by lenders, thereby saving you money over the life of the loan. Closing costs and schedules might also be leaner. However, mortgage assumption is not always possible, and if it is, you may have to make up the difference between the mortgage amount and the home’s current value.

What is required to assume a mortgage?

To assume a mortgage, the seller must have a loan that allows for assumption. These are usually government-insured or -issued mortgage loans. In addition, you may have to submit credentials to the lender and be approved. You may also have to pay the difference between the mortgage amount and the property’s market value.

How much does it cost to assume a mortgage?

Typically, when you assume a mortgage, you may pay some closing costs, but these could be lower than on a new loan. In addition, there may be a one-time funding fee; for instance, on a VA loan, this amounts to 0.5% of the existing mortgage balance. Last but not least: The buyer is usually liable to pay the difference between the remaining balance on the mortgage and the current value of the home.

SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility for more information.

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SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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2023
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Can You Lose Money in an Index Fund?

By | Growing Wealth, invest, Investing | Comments Off on Can You Lose Money in an Index Fund?

As is the case with any investment, you can lose money in an index fund. Still, index funds allow investors to track the market in a low-cost, consistent way, according to most analysts and advisors. That’s because an index fund provides exposure to a diverse selection of publicly traded securities that are intended to perform identically to a market index.

However, index funds don’t always perform in an exact one-to-one ratio, as we will see. But in general, most high-quality index funds perform in close lockstep with their underlying indexes.

How Can You Lose Money in an Index Fund?

All investments carry risk. An index fund, like anything else, can potentially lose value over time.

That being said, most mainstream index funds are generally considered a conservative way to invest in equities (although there are lesser-known index funds that are thought to carry greater risk). This is largely due to the fact that index funds are greatly diversified, distributing risk throughout many securities. Risk is also lowered by reducing an individual’s responsibility in managing the funds — investors can simply buy and hold for years, or even decades.

As you weigh the risks, also keep in mind that most financial experts agree that the biggest risk is not investing at all. While saving money is important, inflation steadily eats away at savings over time.

How Does an Index Fund Work?

Index funds are part of a growing trend of what’s referred to as “passive investments.” Similar to an exchange-traded fund (ETF), an index fund is composed of many different assets packaged into a single security that investors can trade like a regular stock.

When you buy shares of an index fund, many people think that you are almost buying a tiny piece of a share of every company in that index all at once. An S&P 500 index fund, for example, gives investors exposure to most 500 companies in the S&P 500, or so the story goes. And some index funds do work this way.

But in reality, things are not always so straightforward. The goal of an index fund is to track the performance of a stock market index, and the fund can invest in any number of assets to achieve this end. That often does include a substantial amount of holdings of the stocks contained in a specific index, but there can be other assets included as well.

Some funds might not actually hold any of the assets that are present in the index they are supposed to be tracking. Instead, they might invest only in derivatives, like options and futures, that are intended to perform similarly to the index.

Some funds also provide leverage, meaning they are designed to provide returns or losses greater than what their respective index provides. If a fund has 3x leverage, for example, then it might produce a return or loss three times as high as what its index does. Leveraged bets of any kind are generally considered to be riskier and more speculative.

How Likely Are Index Funds to Go to Zero?

Index funds are generally not as volatile as individual stocks because of their diversification. But of course, if the underlying index is volatile, then the index fund will be, too, assuming it tracks the index’s performance well.

Investors who stick to well-established index funds that own real assets probably don’t have too much to worry about — but they aren’t 100% free of risk either.

Markets don’t go up or down in a straight line, so over the short term, funds will fluctuate. But index funds can provide a good option to gain exposure to broad swaths of the market without having to select individual stocks or manage a portfolio actively.

Although any index fund comes with risk of loss, like all investments, some funds may have a real possibility of losing a significant portion of investment capital. Leveraged funds and funds that invest in derivative products have a higher-than-average chance to produce suboptimal returns.

Over long periods of time, though, most indexes have seen large returns, as the large companies that are included in most indexes continue growing.

What Are the Benefits of Investing in Index Funds?

The benefits of index funds involve everything described so far. Low risk and high diversification provide an excellent way to grow wealth steadily over time. For this reason, index funds can be a reasonable option for most long-term portfolios.

For the most part, major index funds with an established track record don’t require much active management. That’s why they fall under the umbrella term “passive investments.” This is another reason why some investors like index funds: They don’t have to keep track of a bunch of different securities, their performance, or their latest news releases and company fundamentals.

Some Common Misconceptions About Index Funds

Not all index funds are created equal, and not all of them work in a simple, straightforward manner. While the general concept may be simple enough, in practice things don’t always work out the same way.

Here are a few notes about some of the most common misconceptions about index funds.

Index Funds Always Perform the Same

Sometimes, some index funds might provide returns less than the actual index they track. This can happen for a number of reasons. A high expense ratio, for example, might mean that there are hidden fees associated with owning the fund, making it more expensive.

To this end, it can be important for investors to make sure their funds won’t underperform. Index funds are generally a good way to minimize bad decisions, but only if someone chooses a fund that has broad exposure and low fees.

All Index Funds Are Low Risk

As mentioned, index funds tend to be on the lower end of the risk spectrum. But not all index funds are created the same. For investors looking for minimal risk, it might be wise to seek out a fund that directly owns shares of stocks, offers the most diversification possible, and has a long-standing track record of performance that mimics its underlying index.

Index Funds Work Well As Short-Term Investments

In general, some advisors suggest that index funds ought to be held for at least five years, if not 10 or more.

Funds of this type don’t make for good short-term investments because they usually don’t move a lot over short time periods, and the fees or commissions involved tend to eat into the meager profits investors might gain.

There are certain leveraged funds and ETFs that are better suited to short-term trading, but we won’t get into those here.

Try Investing With SoFi Invest

Can you lose money in an index fund? Of course you can. But index funds still tend to be an appealing choice for investors due to their built-in diversification and comparatively low risk. Just make sure to note that not all index funds always perform the same, and that now every index fund out there is low-risk.

If you’re beginning your portfolio-building journey you might consider getting started with SoFi Invest®. The platform offers educational content as well as access to financial planners. Plus, the Active Investing platform lets investors choose from an array of stocks, ETFs, or fractional shares.

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Probability of Member receiving $1,000 is a probability of 0.028%.

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Terms and conditions apply. SOFI RESERVES THE RIGHT TO MODIFY OR DISCONTINUE PRODUCTS AND BENEFITS AT ANY TIME WITHOUT NOTICE. To qualify, a borrower must be a U.S. citizen or other eligible status, be residing in the U.S., and meet SoFi's underwriting requirements. Not all borrowers receive the lowest rate. Lowest rates reserved for the most creditworthy borrowers. If approved, your actual rate will be within the range of rates at the time of application and will depend on a variety of factors, including term of loan, evaluation of your creditworthiness, income, and other factors. If SoFi is unable to offer you a loan but matches you for a loan with a participating bank, then your rate may be outside the range of rates listed above. Rates and Terms are subject to change at any time without notice. SoFi Personal Loans can be used for any lawful personal, family, or household purposes and may not be used for post-secondary education expenses. Minimum loan amount is $5,000. The average of SoFi Personal Loans funded in 2023 was around $33K. Information current as of 2/26/24. SoFi Personal Loans originated by SoFi Bank, N.A. Member FDIC. NMLS #696891 (www.nmlsconsumeraccess.org). See SoFi.com/legal for state-specific license details. See SoFi.com/eligibility for details and state restrictions.

✝ To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. However, if you choose a product and continue your application, we will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and may affect your credit.

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