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Jul

2023

A Guide to Delta Neutral Trading Strategies

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

The typical options investor is trying to leverage options trading to speculate on directional moves in the prices of underlying assets. However, there are more sophisticated traders who would like to profit from other characteristics of options.

To pursue these trading strategies, investors need to minimize the effect of price changes and create portfolios that profit from and are more sensitive to these other factors. Delta neutral approaches allow investors to create these portfolios.

What Is Delta?

Delta is one of the Option Greeks and measures how much an option will change in price, given a $1 change in the price of the underlying asset. By definition, the delta of the underlying asset is always 1.

What Does Delta Neutral Mean?

Delta neutral means that a position’s value will not change when there are small market price changes. By holding a combination of assets and options, or combinations of various call and put options, a trader can create a portfolio with an overall delta of zero (in actual practice, very close to zero).

Traders use delta neutral strategies to minimize the effect of price changes while aiming to profit from shifts in implied volatility, the time decay of options, or simply to hedge against price movements.

How Does Delta Neutral Function?

A portfolio’s overall delta is determined by the sum of the deltas of its individual positions. Let’s take a closer look at the delta in options and securities.

Basic Mechanics

A trader holding shares (“going long”) benefits one-for-one from increases in the stock price. The delta for long shares is 1.

Investors short a stock will experience losses one-for-one as the share price rises, but they will benefit in the same amount when it falls. The delta for short shares is -1.

In the options trading world, a long call option has a delta of 0 to 1, while a long put option has a delta of –1 to 0.

Deep in the money long call options are most likely to feature a delta near 1. Deep out of the money long call options will have a delta near 0. At the money long call options typically have a delta near 0.5.

Deep in the money long put options typically have deltas near -1. Deep out of the money long puts have deltas near 0 and at the money long puts have deltas near -0.5.

Deltas values are for each individual security held and need to be adjusted based on your actual holdings. If you own 200 shares of stock, the delta for this position is 200. If you own an at the money call options contract, the delta for this position would be 100 x 0.5 or 50 due to options representing 100 shares of the underlying asset.

If you are writing (“going short”) options, the deltas values are reversed. If you write a call option with a delta of 0.75, then the delta for the position would be -75. Similarly, the delta for shares sold short is -1 per share.

The investor must also be aware that any delta neutral portfolio will only be neutral over a range of asset prices. An option’s delta is always in flux as it moves in and out of the money. A portfolio must be constantly adjusted to maintain delta neutrality – many delta neutral trades must be executed.

An Example of Delta-Neutral in Use

A trader might employ a delta neutral trading strategy when they are long shares of stock but are concerned about a near-term pullback in its price. Assume the trader owns 100 shares of XYZ stock at $100 per share. A long stock position has a delta of 1. Multiplied by 100 shares, the position has a total delta of 100.

The goal of a delta neutral strategy is to use a combination of calls and puts to bring the portfolio’s net delta to 0. One possibility is to purchase at the money put options that have a delta of -0.5. Two of these put option contracts have a total delta of -100 (-0.5 multiplied by 200 options). Recall that an options contract represents 100 shares of stock.

Here, the $100 strike is the delta neutral strike. As the underlying price moves away from $100, the delta of the portfolio will move.

Combining the deltas of 100 shares together with 2 long put option contracts with a -0.5 delta yields a delta neutral portfolio.

Stock position delta = 100 shares x delta of 1 = 100

Long put position delta = 2 contracts x 100 shares/option x delta of -0.5 = -100

Portfolio delta = stock position delta + long put position delta

Portfolio delta = 100 + -100 = 0 or delta neutral

The net position is protected from losses by being long put options while still having exposure to upside from the long stock position. Of course, there is a cost to purchasing put options.

A diagram might help illustrate what is delta neutral.

Profit & Loss Diagram Using the Above Example (Not Including the Put Option Cost)

Profiting From Delta-Neutral Trading

It is possible to profit from changes other than price movements in the underlying stock. For example, an options trader can use delta neutral strategies to benefit from declining or rising volatility. Vega is the Options Greek that tells a trader how much the price of an option will move in response to changes in volatility.

Delta neutral strategies can also be used to profit from time decay or – as in the earlier example – to hedge an existing long stock position. Writing options allows you to benefit from the effect of time decay, but there is a risk of assignment. If the underlying stock price moves significantly, the contracts could be assigned to you.

Shorting Vega

Shorting vega is a more advanced options trading strategy. A delta neutral approach can be used to benefit from collapsing volatility.

You might look to short volatility after a period of extreme movements in the market or a single stock. The key is to short vega when implied volatility is still high and you expect it to come back down.

When implied volatility is high, you pay a significant premium to be long options. You can take advantage of expensive options when implied volatility is high by selling options while still being delta neutral. The risk is that implied volatility levels continue to jump, which can lead to losses on a short vega play.

Waiting for Collapse in Volatility

A short vega position relies on the implied volatility on the underlying security to drop in order to turn a profit. It might take patience for implied volatility to drop to historical norms. To remain delta neutral, other positions might have to be put on to mitigate the risk of a change in the underlying stock price.

Pros and Cons of Delta Neutral Positions

Some of the pros of crafting a delta neutral portfolio have been highlighted, but there are downsides as well. Having to closely monitor your portfolio can be a burden, while trading costs mount as you constantly layer on or reduce hedges to keep near delta neutral.

Pros	Cons
Profit from variables other than the price movement of the underlying asset	Requires frequent trades, which could be costly, to maintain a delta near 0
Traders hold stock for the long run while protecting against near-term declines	Deltas are constantly changing resulting in being over- or under-hedged

Delta Neutral Straddle

A delta neutral straddle uses a combination of puts and calls to keep the position’s delta near zero while having exposure to volatility changes.

For example, if XYZ stock trades at $100, and it’s at the money call has a delta of 0.5 and it’s at the money put has a delta of -0.5, you can buy the put and call with the goal of selling them after implied volatility jumps. With this delta neutral long straddle strategy, your delta is effectively 0 but you are long volatility.

A delta neutral short straddle is an options trade that seeks to profit from minimal changes in the underlying stock price and a large drop in implied volatility. So, the reverse of a long straddle can be used when you believe implied volatility will drop.

Other options trading strategies used to profit from changes in volatility and time decay are calendar spreads, diagonal spreads, iron butterflies, iron condors, among others.

The Takeaway

Building and maintaining a delta neutral portfolio can be a challenging task, but profiting from time decay and changes in volatility can make it worthwhile and profitable.

Delta neutral trading can also hedge your portfolio from short-term declines while continuing to hold stock for the long-term.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

With SoFi, user-friendly options trading is finally here.

FAQ

How do you make money with a delta neutral strategy?

You profit from a delta neutral option strategy when there are changes in a stock’s variables other than its share price. Changes in implied volatility create opportunities to go long or short volatility while being agnostic to the stock price’s change. You can also benefit from time decay by selling options while being delta neutral.

What is a delta neutral strike?

A delta neutral strike marks the price at which a portfolio is precisely delta neutral. In practice, it is more of a theoretical price rather than an exact level. When the underlying asset price moves up or down from the delta neutral strike, its delta will stray from zero; it will take additional hedging trades to get back to delta neutral.

How can you calculate the value of your delta neutral position?

To calculate your position’s delta, simply multiply each security’s delta by your position size. For example, one call option contract with a delta of 0.75 has a delta of 75 (0.75 x 100 options per contract). While being long 100 shares of stock with a delta of 1 has a delta of 100 (1 x 100 shares).

You combine the deltas of all positions in your portfolio to determine your overall delta. At that point, you can trade options to make your portfolio delta neutral.

Photo credit: iStock/Delmaine Donson

SoFi Invest®

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

Jul

2023

What Diagonal Spreads Are & How They Work

What Is a Diagonal Spread and How Does It Work?

By Paulina Likos | Growing Wealth, invest, Investing | Comments Off

A diagonal spread is an options trading strategy that involves taking a long and short position on the same stock with different strike prices and different expiration dates. It’s a combination of a vertical spread and calendar spread.

Using this strategy can allow the trader to get an early payday if the stock moves in a direction that’s in their favor. The way it works is the trader makes two options trades — either call options or put options simultaneously, with different strike prices and expiration takes.

Diagonal Spreads Defined

Diagonal spreads combine a two-step options trading strategy and are considered an advanced trading tactic. It’s a combination of a calendar spread and a short call or put spread. These positions have different expirations and different strikes which spread off diagonally, hence the name of the strategy.

A calendar spread is when a trader buys a contract with a longer expiration date while going short on an option with a near-term expiration date with the same strike price. But if two different strike prices are used, this is a diagonal spread.

A diagonal spread includes a calendar spread, also referred to as a horizontal spread or a time spread, combined with a vertical spread, because different strike prices are involved.

How Diagonal Spreads Work

A long put diagonal spread involves purchasing a put for some time in the future while selling a put in the short-term. Purchasing an option in the later term tends to be more expensive due to the embedded value of time. On the other hand, the trader sells the nearer term option to lower the cost of the other option. Traders usually use diagonal spreads when they have conviction on a stock’s movement while minimizing the effects of time.

A diagonal bull spread becomes a valuable trade when the price of the stock increases, while a diagonal bear spread increases in value when the stock price decreases.

Diagonal spreads require experience because traders have to account for volatility and have a good sense of timing.

Setting Up a Diagonal Spread

When traders are bullish on a stock, they generally use call options vs. using put options when they’re bearish on a stock.

The most common way to set up a diagonal spread is to buy a back month option that is in the money, which is a futures contract whose delivery dates are further into the future. Then, you sell a front month option with a strike price that is out of the money, which is a contract that has a near-term expiration date.

Setting up a diagonal spread in this manner would constitute a debit spread, though credit spread structures can also be used.

Maximum Loss

When a stock’s price rises, the maximum loss is equal to the premium paid when buying a call. If the stock falls, the maximum loss is the difference between the strike prices plus or minus the option premium paid or received.

Maximum Profit

It can be difficult to anticipate what the maximum gain may be since traders can’t know what the back-month option will be trading at when the front-month option expires as a result of shifting volatility expectations. In a long diagonal spread, the stock price must be near the short strike for a trade to go in the market participant’s favor.

The max profit potential for a short diagonal call spread is the net credit received minus commissions. If the strike price plummets below the short call, the value of the spread will be close to zero and the credit received is profit.

On the other hand, the max profit scenario of a short diagonal put spread is when the stock price soars above the strike price of the sold higher strike put option, as the value of the spread nears zero and the credit received is profit.

Breakeven Point

The breakeven point cannot be calculated, rather it can be estimated. The breakeven price at expiration for a long call is below the strike price of the short call. During expiration of a long call, the breakeven point is the stock price at which the price of the short call is the net credit received for the spread.

Traders are not able to predict what the breakeven stock price will be because it depends on market volatility, which can impact the price of the short call.

Diagonal Spread Examples

In one example, a trader is bullish on ABC stock, currently priced at $300. If the front month is January and the back month is February, the trader may want to purchase a $298 strike call with February expiry, which is in the money. Then the trader sells a $302 strike call with January expiry, which would be out of the money. This would give the trader a four-dollar wide diagonal spread.

In another scenario, a trader is bearish on XYZ stock at a current market price of $129. To set up a diagonal spread, the trader could buy a $132 February put, which would be several dollars in the money. Next, the trader could sell a $126 January put, which would be a few dollars out of the money. This trade would be a six-dollar wide diagonal spread.

Types of Diagonal Spreads

There are different types of diagonal spread strategies traders can use to get their desired outcome. Here are several diagonal spreads traders can try:

1. Long Call Diagonal Spreads

To execute on a long call diagonal spread, traders must buy an in the money call option with a longer term expiration date and then sell an out of the money call option with a nearer term expiration date. Traders can use this advanced options strategy if they are mildly bullish on a stock in the near term and very bullish in the longer term. An ideal set up for a long call diagonal spread is during times of low volatility as you do not want your trade to be disrupted by sharp price swings.

2. Long Put Diagonal Spreads

To execute on a long put diagonal spread, traders must buy an in the money put option with a longer term expiration date and then sell an out of the money put option with a nearer term expiration date that has an out the money strike. Traders typically use long put diagonal spreads to mimic a covered put position.

3. Short Call Diagonal Spreads

A short call diagonal spread is when traders sell a long-term call with a lower strike price and buy a shorter-term call with a higher strike price. A trader benefits from a short call option when the price of the underlying asset falls, thus making this a bearish strategy.

4. Short Put Diagonal Spreads

A short put diagonal spread involves selling a longer-term put with a higher strike price and buying a shorter-term put with a lower strike price. This is a bullish strategy, as the trader benefits if the underlying asset goes up in price, making both options expire worthless and netting the investor the net credit earned at the beginning of the trade.

5. Double Diagonal Spread

A double diagonal spread is when a trader buys a longer-term straddle and sells a shorter-term strangle, a trade that benefits from time decay and an increase in volatility. Traders setting up a double diagonal are long the middle strike calls and puts, which expire further in the future, and short out of the money call and put options with sooner expiries. The ideal outcome for double diagonals is to stay between the two OTM strike prices as they approach expiration.

Risks of Diagonal Spreads

The biggest risk traders have in diagonal spreads is overpaying for the diagonal spread. That said, the maximum risk is the debt a trader incurred to enter the position. If traders pay too much for their diagonal spreads they can remain unprofitable.

Market volatility can be used to the trader’s advantage when using diagonal spreads, although it can also pose a risk to such trades. Depending on the level of volatility, it can substantially change the price of the option and impact the trader’s profit potential. Diagonal spreads are an advanced trading strategy so traders who are experienced in dealing with volatility are best suited to incorporating diagonal spreads in their investment strategy.

The Takeaway

Setting up a diagonal spread correctly is an important part of the profit potential of the strategy, otherwise traders are at risk of losing money. This advanced options trading strategy requires traders to make both long and short trades, either with calls or puts, that have different expiration dates and strike prices. Traders should know these option trades are lined up diagonally from one another.

With SoFi, user-friendly options trading is finally here.

Photo credit: iStock/percds

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

Jul

2023

Angel Investors: What They Are and How to Find Them

By Kate Ashford | Growing Wealth, invest, Investing | Comments Off

An angel investor is typically a high-net-worth individual or a group of wealthy individuals who invest their money in a venture at an early stage in return for an equity share.

There are several ways a new small business might try to secure money for expansion or growth, from friends to bank lenders to joining a startup accelerator program. Angel investors are another option that can provide a capital infusion, but there are trade offs when accepting funds in exchange for a stake in a new company.

What Is an Angel Investor?

If you’ve ever watched the show Shark Tank, you’ve seen one type of angel investor in action. On the show, a group of wealthy investors listen to pitches from entrepreneurs who are looking for funding for their small business or startup. In exchange for funding, these investors generally ask for an ownership share in the business.

Angel investors can also be personal friends or colleagues of the entrepreneur. Typically they’re wealthy enough to provide a significant amount of money, despite the risks the startup could fail.

Recommended: What Is Active Investing?

That said, angel investors typically invest in startups that have the potential to grow and have minimal downside risk in the long term. An angel investor may provide a one-time investment in a company, or they may provide ongoing support. They may also be called private investors, seed investors, or just “angels,” for short.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Who Can Be an Angel Investor?

Angel investors were once required to be accredited investors, which demanded, among other things, that they have a net worth of $1 million in assets, not including personal residences — or yearly income greater than $200,000 alone, or $300,000 for a household for the previous two years. (Anyone who holds a Series 7, Series 65, or Series 82 in good standing also qualifies).

This was meant to limit angel investing — which is a risky practice — to those who ostensibly had enough assets to safely dabble in it. In recent years, however, anyone can be an angel investor.

Ways to Become an Angel Investor With Less Cash

Angel investing is undoubtedly risky — businesses fail all the time. However, lately it is possible to get involved in angel investing without putting tens of thousands of dollars on the line. (A smaller investment won’t reduce the risk, but it may potentially reduce an investor’s total loss.) These crowdfunding platforms enable smaller investors to dip their toes in the water:

• WeFunder is an equity crowdfunding site that allows you to invest as little as $100 in startups and small businesses. The site encourages investors to invest in companies and products they love and believe in. Although the investment is smaller than might be typical, the site still describes these investments as risky and advises that people don’t invest money they can’t afford to lose.

• SeedInvest is an equity crowdfunding site that allows users to get started with $1,000. The company vets all startups on the platform and offers a variety of investment opportunities. The site notes that early-stage investors should expect to hold their investments for at least five years, and that there is no guarantee on returns.

Recommended: Tips for Investing in Tech Stocks

What Are the Pros of Using Angel Investors?

There are a number of benefits to using angel investors to help finance a venture.

Less risk

If you take out a loan to finance your business, you’ll still be expected to pay it back, whether or not your venture is a success. Angel investors generally understand the risk of investing in a startup business, and may not expect any return on capital if the business goes south.

Expertise

If angel investors also happen to be experts in your business, they can offer advice and guidance based on their years of experience.

Credibility

Angel investors are often well-known in their field, and if they invest in your idea, it can boost your reputation and status to have them on board.

They’re Willing to Take a Leap

Unlike a bank, which may need more concrete proof that you’re onto something big, an angel investor might be more willing to gamble on your great idea.

Better Chance of Success

Companies with angel investor interest stand a greater chance of survival than those with less angel investor interest, according to findings from the National Bureau of Economic Research. Having angel investment doesn’t mitigate the risk of starting a business, but it’s possible that having angel investors on board can provide some oversight or accountability that might be beneficial.

What Are the Cons of Angel Investors?

There are also some potential disadvantages to having angel investors.

Loss of Full Ownership

Angel investors often provide funding in return for a share of the business, so involving angel investors means giving up some of your control. It also means that if the business succeeds, they’ll share in the proceeds.

They May Add Pressure

Angel investors aren’t giving you money out of kindness and good will. They may be aggressive investors who expect to see a high return on their investment. If they’re sinking money into your venture, it may feel there’s more riding on your success or failure.

Funding May Be Slow

Finding angel investors can take time, and the process of securing backers — and for the cash to find its way to your venture — can take even longer.

It’s a Competitive Market

Even if you have a brilliant idea, there’s no guarantee that you’ll be able to find backers for it. Although there were 334,680 active angel investors in 2021, only 64,480 entrepreneurial ventures received angel funding, according to an analysis by the University of New Hampshire Center for Venture Research.

💡 Quick Tip: Are self directed brokerage accounts cost efficient? They can be, because they offer the convenience of being able to buy stocks online without using a traditional full-service broker (and the typical broker fees).

Where to Find Angel Investors

Startups looking for early-stage investors can look in several places.

Friends and family

Most commonly, startups get much of their initial investment from friends and family who believe in their idea and want to support the venture.

High-Net-Worth Individuals

Networking within your business community may allow you to make connections with people who’d be interested in helping to back your idea. It can be helpful to join local business, trade, and community organizations. Attend meetings and trade fairs, and have your elevator pitch well-honed.

Angel Funding Groups

There are a number of sites that seek to match entrepreneurs with angel investors, including:

Angel Capital Association : A collective of accredited angel investors

Golden Seeds : A group whose members focus on women-led ventures

Angel Investment Network : A network that seeks to connect entrepreneurs with business angels

Crowdfunding sites

While traditional angel groups seek to match entrepreneurs with accredited investors, crowdfunding sites allow lots of smaller investors to pitch in to move your venture along. (Picture a GoFundMe for your business idea.) These include SeedInvest, LocalStake, WeFunder, and Fundable.

You’ll likely have to apply to have your idea or business vetted by the site before they’ll present your project to their members.

The Takeaway

Angel investors are typically high-net-worth individual or group backers that support startup and early-stage business ventures. But lately, opportunities have opened up for individuals of all types to invest in companies that have recently launched.

For entrepreneurs, an angel investor can be an enormous help, both in terms of financing their dream as well as providing guidance if they have relevant business experience. On the flip side, some entrepreneurs may find there is added pressure to deliver when an angel investor is backing their startup.

Whether you’re interested in finding an angel investor for your own startup idea, or thinking of becoming one, there are a number of risks associated with this type of business. Consider the pros and cons in light of your own financial goals, as there are many different paths forward.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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

Jul

2023

How to Pay Off Debt in 9 Steps

By Austin Kilham | Debt Payoff, Financial Independence, invest | No Comments

Being debt-free can be a terrific feeling of freedom. However, many of us don’t know that sensation. According to Experian, the average American is carrying $101,915 in debt. And paying off the amount that you owe — whether it’s credit card debt, student loans, or something else — can be a considerable challenge.

While each person’s finances are different, there are smart strategies to pay off debt effectively and quickly. That will not only likely reduce your money stress and improve your finances, it can also free up funds to help you achieve some big-picture goals, whether that means funding a wedding or growing your toddler’s college fund.

Here, you’ll learn why it’s important to pay off debt, the best how-tos, and tips for managing debt as you work to shake it off.

Why Is It Important to Pay Off Debt?

Granted, not all debt should necessarily be paid off ASAP. There’s “good debt,” which is typically lower interest and can have a positive impact on your financial status. For example, if you have a mortgage, that is likely low-interest and it is helping you build equity and, by extension, your net worth.

However, there is also “bad debt” of the high interest variety, like credit card debt, which can wind up having a negative effect on your finances and your life. Some examples of why this kind of debt can be problematic:

• It takes up funds that could otherwise be put towards long-term goals like retirement or short-term goals, such as a vacation fund.

• It gives you more bills to pay.

• It can cause you stress.

• It can have a negative impact on your credit score, which can have further ramifications, such as making it more expensive to open other lines of credit.

• It means you are subject to the lender’s decisions (such as raising your interest rate).

When you are debt-free, you likely don’t have to deal with those issues any longer. So here are smart debt payoff strategies to help you take control of your money.

💡 Quick Tip: With low interest rates compared to credit cards, a debt consolidation loan can substantially lower your payments.

steps to paying off debt

1. Create a Budget

A budget can help you understand and create a plan for where your money is going. This is where you can start to figure out how to live within your means to avoid accumulating new or more debt in the future, such as credit card debt.

• To start your budget, take an inventory of all of your after-tax income. If you have a job, simply look at your net paycheck and multiply the number by how many times you’re paid each month.

• Next, tally up necessary expenses. These might already include debt payments such as your student loans or a car payment. They can also include rent, utilities, insurance payments, groceries, and so on.

• Subtract this total from your income and what you have left represents the money available for discretionary spending. If the amount of money you’re spending on discretionary expenses exceeds the amount you have available, you’ll likely need to make some adjustments to how you spend.

• To pay off debt, focus a portion of the available discretionary income on debt payments. One approach is known as the 20/10 rule, which says that you should put no more than 20% of your annual take-home pay or 10% of your monthly income towards consumer debt.

2. Set Realistic Goals

It takes a lot of discipline to get debt-free. Setting measurable and achievable goals can help you stay on track. Think carefully about how much money you actually are able to put toward your debts each month. Include factors like how much spending you can reasonably cut and how much you might be able to add to your income.

Don’t factor in extra income unless you’re sure you’ll be able to come up with it. Once you settle on your monthly amount, you can calculate how many months it will take you to pay your debt off.

For example, say you have $500 dollars per month to help you pay off $10,000 in credit card debt with a 19.99% interest. With an online credit card payoff calculator, you can determine that it will take you about 25 months to pay off your card. So, a reasonable goal might be two years to get out of debt, which even builds in a little wiggle room if you can’t come up with a full $500 in one of those months.

3. Try a Payoff Method

Once you’ve identified funds you can use to pay down debt, there are a number of strategies you can use to put that money to work towards different debts you’re shouldering.

The Snowball Method

Here’s how the snowball method of debt repayment works:

• List your debts in order of smallest balance to largest. Look exclusively at the amount you owe, ignoring the interest rate.

• Make minimum payments on all the debts to avoid penalties. Make all extra payments toward paying off the smallest debt.

• Once the smallest debt is paid in full, move on to the next largest debt and so on. Use all of the money you were directing toward the previous debt, including minimum and extra payments, to pay off the next smallest. In this way, the amount you’re able to direct toward the larger debts should grow or “snowball.”

One downside to the snowball method is that while targeting your smaller debts first, you may be holding onto your higher interest debts for a longer period of time.

However, you should also theoretically get a psychological boost every time you pay off a debt that helps you build momentum toward paying all of your debts off. And if this extra push can help keep you motivated to continue eliminating debt, the benefits of this strategy might outweigh the extra costs.

The Avalanche Method

The avalanche method takes a slightly different approach:

• List your debts in order of highest interest rate to lowest. Once again, commit to making minimum payments on all of your debts first.

• Make any extra payments toward your highest interest rate debt. As you pay each debt off, move on to the next debt with the highest rate. The debt avalanche method minimizes the amount of interest you pay as you work to get debt-free, potentially saving you money in the long-term.

The Fireball Method

This is a hybrid approach to the snowball and avalanche methods:

• Group your debts by good and bad debt. As noted above, good debts are those that help you build your future net worth, like a mortgage, business loan, or student loan, and typically have lower interest rates. Bad debts have high interest rates and work against your ability to save; think credit card debt. (Btw, credit card debt should always be characterized as bad debt even if you are taking advantage of a 0% interest promotion.)

• Next, list your bad debts in order from smallest to largest based on balance size. Continue making minimum payments on all debts, but funnel extra cash toward paying off the smallest of the bad debts.

• Work your way up the list until all your bad debts are paid off. You can pay off your good debts on a regular schedule while investing in your future. Once you’ve blazed through your bad debt, you may even have extra cash to help you accomplish your long-term goals.

Choose the strategy that fits your personality and financial situation to increase the chances for success.

4. Complete a Balance Transfer

A balance transfer allows you to pay off debt from one or more high-interest credit cards (or other high-interest debt) by using a card with a lower interest rate. This strategy has a number of benefits.

• First, it helps you get organized. Staying on top of one credit card statement might be easier than keeping track of many cards.

• This strategy also helps you free up the money you were paying toward higher interest rates, which you could use to accelerate your debt payments.

Research what’s available carefully. Some credit cards offer teaser rates as low as 0% for a set period of time, such as six months to a year or even longer. It may make sense to take advantage of one of these deals if you think you can pay down your debt within that time frame.

However, when these teaser rates expire, the card might jump to its regular rate, which could be higher than the rates you were previously paying.

5. Make More Than the Minimum Payment

Credit cards allow you to make minimum payments — small portions of the balance you owe — until your debt is paid off. While this might seem convenient on the surface, this system is stacked in the credit companies’ favor. Making minimum payments can cost more in the long run than making larger payments and paying down debt faster.

That’s because as you make minimum payments, the remaining balance continues to accrue interest. Consider a credit card balance of $5,000 with a 15% interest rate. According to this credit card interest calculator, if you only make minimum payments of $112.50 per month, it will take you 64 months (5 years and 4 months!) to pay off your debt of $7,344. And in that time you will have spent more than $2,344 on interest payments alone.

In an ideal world, you would pay your credit card balance off each month and wouldn’t owe any interest. But, if that’s not possible, consider paying as much as you can to minimize the cost of high interest rates.

6. Find Extra Cash

Finding the cash to pay off your debt can be tough, especially if you’re looking to accelerate your debt payments. The most obvious place to start is by cutting unnecessary expenses.

For example, you might save money on streaming services by dropping some or all of your subscriptions, or give up your gym membership while you’re getting your debt in check. You may also try negotiating lower rates for some necessary expenses such as phone or internet bills, or consider starting a side hustle that can boost your income.

You can also use any windfalls, such as extra cash from tax returns, bonuses at work, or generous birthday gifts, to help accelerate your debt payments.

7. Avoid Taking on More Debt

While you’re paying off debt, it’s important that you work hard to not add to your debt. If you’re trying to pay off a credit card, you might want to stop using it. You may not want to cancel your credit card, but consider putting it somewhere where it’s not easily accessible. That way you’ll be less tempted to use it for impulse buys.

It can also be helpful to track your spending with a free budget app to help understand where your money is going and how not to increase your debt.

8. Consolidate Debt

Consolidating is another strategy that makes use of lower interest rates to pay off debt.

• When you take out a loan, it will come with a fixed interest rate and a set term. When you consolidate your debts, you are essentially taking out a new loan to pay off debts, hopefully with a better interest rate or term.

• A new loan with a lower interest rate can save you money in the long run, especially if you’re carrying a sizable balance. You may also be able to lower your monthly payments to make a budget more manageable on a month to month basis — or you may be able to shorten your terms, which can let you pay off the loan faster. Do keep in mind extending the term of the loan could lead to lower monthly payments but you may end up paying more in interest over time.

• You may want to consider consolidating if you’ve established your credit history since you took out your loan. That may mean banks are more willing to trust a borrower with a loan and will give them more favorable rates and terms.

• Also, keep an eye on the prime interest rate set by the Federal Reserve. When the Fed lowers interest rates, banks often follow suit, providing you with a possible chance to find a loan with lower interest rates.

9. Reward Yourself

Paying off debt can be a challenging process. That’s why it’s so important to treat yourself as you reach debt milestones.

Tethering productive behavior to rewards is a process that Wharton business school professor Katherine Milkman calls “temptation bundling.” This process can help you boost your willpower and stick to your goals.

So, choose a reward and tie it to a debt milestone like paying off a credit card, or paying off 10% of your debt. Each of these steps puts you closer to being debt-free, and that’s worth celebrating. When you reach a goal, indulge in a free or budget-friendly reward.

Debt Payoff Tips

Paying off debt often requires patience and persistence. Here’s some smart advice to address common concerns and help keep you going as you whittle down that debt.

What Are Some Common Mistakes to Avoid When Paying off Debt?

Some common mistakes when paying off debt are hiding from the situation (that is, not looking at how much you owe and creating a plan), taking out high interest payday loans, and, in some cases, taking out a home equity loan. Here’s a closer look at each:

• It can be a common mistake to not dig in, review the full picture, and make a plan. Some people would rather be in denial and just keep paying a little bit here and there. Knowing your debt and developing a way to pay it off can be the best move.

• Taking out a payday loan or other high-interest option to make a payment. This can make a tough situation worse by adding more money owed to your situation. A personal loan might be a better option with lower rates.

• Tapping your home equity. Credit card debt is unsecured; you don’t put up anything as collateral. A home equity loan, however, uses your home as collateral. Yes, a home equity loan can be a helpful option in some situations, but if you use that equity to continue spending at a level your income can’t support, that can mean bigger problems lie ahead. You could wind up losing your home.

How Can I Balance Paying off Debt with Saving for Other Financial Goals?

To manage both debt repayment and saving, it’s important to make sure you keep current on paying what you owe. Next, you might want to create a budget, cut your spending, and automate your finances (which will send some money to savings) to help maintain a good balance. Here’s guidance:

• Create a budget, keep paying off your debt, and work to create an emergency fund (even saving $20 or $25 a month is a good start).

• Commit to cutting your spending. Some people like gamifying this: Say, one month, you vow to not eat dinner out; another month, you decide to forgo buying any new clothes.

• Automate your finances. This can be as simple as setting up a recurring transfer from your checking account to savings just after payday. That whisks some money into savings (a small amount is fine), and you won’t see it sitting in checking, tempting you to spend it.

What Are My Debt Relief Options if I’m Struggling to Make Payments?

Some ways to get help with debt relief can include a balance transfer credit card, a personal loan, a debt management plan, and (if no other options are possible) considering declaring bankruptcy. If you are having a hard time with debt payoff, there are several options:

• As mentioned above, you might take advantage of zero-percent balance transfer credit card offers.

• You can contact your creditors and see if they will lower your interest rate or otherwise reduce your burden.

• You might consider a personal loan (mentioned above) to pay off high-interest debt with a lower-interest loan.

• You could participate in a debt management plan that consolidates your debt into one payment monthly that is then divvied up among those to whom you owe money. Look for a plan that is backed by a reputable organization such as the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America.

• You might decide to declare bankruptcy; the most common form is known as Chapter 7 liquidation, and can get rid of credit card debt, medical debt, and unsecured personal loans. Educate yourself carefully to see if you qualify, and be sure you understand the long-term impact it may have on your personal finances.

The Takeaway

Digging yourself out of debt can be a challenging process, but with a well-crafted plan and discipline, it can be achieved. Evaluate your spending habits, determine how you are going to prioritize your debts, and stick to your plan by setting small, measurable goals. One option people consider is consolidating multiple high-interest debts into a one personal loan with one payment. However, note that extending the loan term could lead to lower monthly payments, but you may end up paying more interest in the long run.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.

SoFi’s Personal Loan was named NerdWallet’s 2024 winner for Best Personal Loan overall.

FAQ

Why is it important to have a plan to pay off debt?

It’s important to have a plan to pay off debt so you can be organized and strategic in this effort. Only by knowing the full extent of your debt and your resources can you make a plan. Whether you choose to use a method like the snowball or avalanche technique, take out a personal loan, or try a debt management program, it’s vital to know just where you stand.

What are some strategies for dealing with multiple sources of debt?

If you have multiple sources of debt, you may want to research the snowball, avalanche, and fireball methods of paying down what you owe. These consider such factors as how much you owe and the interest rate you are being charged and can help you prioritize how you repay the debt. These strategies can help focus your efforts and contribute to your success.

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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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Jul

2023

What Is an Expense Ratio?

By Austin Kilham | Growing Wealth, invest, Investing, Terminology | Comments Off

The expense ratio is the annual fee that mutual funds and exchange-traded funds (ETFs) charge investors, to cover operating costs. The fee is deducted from your investment, reducing your returns each year — which is one reason why expense ratios have been shrinking.

Typically, investors may look for funds that offer lower expense ratios, as high expense ratios can take a substantial bite out of long-term returns, affecting investors’ financial plans.

Here’s a look at how expense ratios are calculated, what they encompass, and other factors worth considering when choosing a mutual fund or ETF to invest in.

How Expense Ratios Are Calculated

Though individual investors typically won’t find themselves in a situation where they need to calculate an expense ratio, it’s helpful to know how it’s done. To calculate expense ratios, funds use the following equation:

Expense Ratio = Total Fund Costs/Total Fund Assets Under Management

For example, if a fund holds $500 million in assets under management, and it costs $5 million to maintain the fund each year, the expense ratio would be:

$5 million/$500 million = 0.01

Expressed as a percentage, this translates into an expense ratio of 1%, meaning you would pay $10 for every $1,000 you have invested in this fund.

As you research funds you may come across two terms: gross expense ratio and net expense ratio. Both have to do with the waivers and reimbursements funds may use to attract new investors.

• The gross expense ratio is the figure investors are charged without accounting for fee waivers or reimbursements.

• The net expense ratio takes waivers and reimbursements into account, so it should be a lower amount.

How Expense Ratios Are Charged

A fund’s expense ratio is expressed as a percentage of an individual’s investment in a fund. For example, if a fund has an expense ratio of 0.60%, an investor will pay $6.00 for every $1,000 they have invested in the fund.

The cost of an expense ratio is automatically deducted from an investor’s returns. In fact, when an investor looks at the daily net asset value of an ETF or a mutual fund, the expense ratio is already baked into the number that they see.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

The Components of an Expense Ratio

The fees that make up the operating costs of a mutual fund or ETF can vary. Generally speaking, the investment fees included in an expense ratio will include the following:

Management Fees

The management fee is the amount paid to the person/s managing the money in the investment fund — they make decisions about which investments to buy and sell and when to execute trades. Management fees can vary depending on how much activity is required of these managers to maintain the fund.

Custodial Fees

Custodial fees cover the cost of safekeeping services, the process by which a fund or other service holds securities on an investor’s behalf, guarding the securities from being lost or stolen.

Marketing Fees

Also known as 12b-1 fees, marketing fees are used to pay for the advertising of the fund, some shareholder services, and even employee bonuses on occasion. FINRA caps these fees at 1% of your assets in the fund.

Other Investment Fees

Investors may be forced to pay other investment fees when they buy and sell mutual funds and ETFs, including commissions on trades to a broker. The cost of buying and selling securities inside the fund is not included as part of the expense ratio. Additional costs that are not considered operating expenses include loads, a fee mutual funds charge when investors purchase shares. Contingent deferred sales charges and redemption fees, which investors pay when they sell some mutual fund shares, are also paid separately from the expense ratio.

How to Research Expense Ratios

Luckily, you do not have to spend your time calculating expense ratios on your own. The Securities and Exchange Commission (SEC) requires that funds publish their expense ratios in a public document known as a prospectus. The prospectus reports information important to mutual fund and ETF investors, including investment objectives and who the fund managers are.

Online brokers often allow you to look up expense ratios for individual investment funds, and they may even offer tools that allow you to compare ratios across funds.

Average Expense Ratios

Expense ratios vary by fund depending on what investment strategy it’s using. Passively managed funds that frequently track an index, such as the S&P 500 index, and require little intervention from managers, tend to have lower expense ratios. ETFs are usually passively managed, as are some mutual funds. Other mutual funds may be actively managed, requiring a heavier touch from managers, which can jack up the expense ratio.

Expense ratios have been falling for decades, according to the most recent Morningstar Annual U.S. Fund Fee study, released in June 2022. “In 2021, the asset-weighted average expense ratio of U.S. open-end mutual funds and ETFs was 0.40%, compared with 0.87% in 2001,” the report states.” While that difference may seem slight, investors saved an estimated $6.9 billion in fund expenses in just one year.

💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

What’s a Good Expense Ratio?

When considering expense ratios across mutual funds and ETFs, it’s helpful to use average expense ratios as a benchmark to get an idea of whether a specific expense ratio is “good.”

Investors may want to target funds with expense ratios that are below average. The lower the expense ratio, the less expensive it is to invest in the fund, meaning more profits would go to the investor vs. the fund.

That said, some investors may prefer to invest in actively managed funds, which typically charge higher fees than passive or index funds.

Looking Beyond Expense Ratios

When comparing mutual funds and ETFs, an investor might choose to consider other factors in addition to expense ratios.

It can be a good idea to consider how a particular fund will fit in their overall financial plan. For example, individuals looking to build a diversified portfolio may want to target a fund that tracks a broad index like the Nasdaq or S&P 500. Or, investors with portfolios heavily weighted in domestic stocks may be on the hunt for funds that include more international stocks.

And it’s also a good idea to know the key differences between mutual funds and ETFs. ETFs, for example, are generally designed to be more tax efficient than mutual funds, which can also have a big impact on an investor’s ultimate return. ETFs are generally lower in cost than mutual funds as well.

The Takeaway

Expense ratios seem small, but they can have a big impact on investor returns. For example, if an individual invested $1,000 in an ETF with a 6% annual return and a 0.20% expense ratio, and continued making a $1,000 investment each year for the next 30 years, they would earn $81,756.91, and spend $3,044.76 on the fund’s expenses.

But expense ratios are only one of many factors to consider when choosing a mutual fund or ETF. Fundamentally your investment choices have to fit into your larger financial plan. But cost should always be a concern.

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.

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