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Volume 15, Issue 7

Understanding Interest Rates

When discussing bank accounts, investments, loans, and mortgages, interest is an important concept to understand. Interest is the price you pay for the temporary use of someone else’s funds; an interest rate is the percentage of a borrowed amount that is attributable to interest. Whether you are a lender, a borrower, or both, it is important to consider how changing interest rates may affect your financial decisions.

The Purpose of Interest

Borrowing money can help you accomplish a variety of financial goals, and the cost of borrowing is interest. When you take out a loan, you receive a lump sum of money up front and are obligated to pay it back over time, generally with interest. Because of the interest expense, you end up owing more than you borrowed. The tradeoff, however, is that you receive funds to accomplish your goals, such as buying a house, funding a college education, or starting a business. Given the cost of interest, which can add up significantly over time, make sure that any debt you assume is affordable and worth the cost over the long term.

To a lender, interest represents compensation for the service and risk of lending money. In addition to giving up the opportunity to spend the money right away, a lender assumes certain risks. One obvious risk is that the borrower will not pay back the loan in a timely manner, if ever. Inflation creates another risk. In general, prices tend to rise over time; therefore, goods and services will likely cost more by the time a lender is paid back. In effect, the future spending power of the money borrowed is reduced by inflation because more dollars are needed to purchase the same amount of goods and services. Interest paid on a loan helps to cushion the effects of inflation for the lender.

Supply and Demand

Interest rates often fluctuate, according to the supply and demand of credit, which is the money available to be loaned and borrowed. In general, one person’s financial habits, such as carrying a loan or saving in fixed-interest accounts, will not affect the amount of credit available to the economy enough to change interest rates. However, a general trend in consumer banking, investing, and debt can have an effect on interest rates. Businesses, governments, and foreign entities also affect the supply and demand of credit according to their lending and borrowing patterns. An increase in the supply of credit, often associated with a decrease in demand for it, tends to lower interest rates. Conversely, a decrease in supply of credit, often coupled with an increase in demand for it, tends to raise interest rates.

The Role of the Fed

As a part of the U.S. government’s monetary policy, the Federal Reserve Board (the Fed) manipulates interest rates in an effort to control money and credit conditions in the economy. Consequently, lenders and borrowers can look to the Fed for an indication of how interest rates may change in the future.

In order to influence the economy, the Fed buys or sells previously issued government securities, which affects the Federal funds rate. This is the interest rate that institutions charge each other for very short-term loans, and it determines the interest rates banks use for commercial lending. For example, when the Fed sells securities, money from banks is used for these transactions; this lowers the amount available for lending, which then leads to a rise in interest rates. In contrast, when the Fed buys government securities, banks are left with more money than is needed for lending; this increase in supply of credit, in turn, lowers interest rates.

Lower interest rates tend to make it easier for individuals to borrow. Since less money is spent on interest, more funds may be available to spend on other goods and services. Higher interest rates are often an incentive for individuals to save and invest, in order to take advantage of the greater amount of interest to be earned. As a lender and a borrower, it is important to understand how changing interest rates may affect your saving and borrowing habits. This knowledge can help you make wise decisions as you pursue your financial goals.

Straighten Up Your Financial House

Is your financial house in order? From time to time, it’s good to review and organize. Use some of the following helpful hints to make the task a little easier and more worthwhile:

1. Clean the “attic.” That’s the spot where you have stored items such as old, unused credit cards, bank account statements for accounts under $10, and savings bonds you forgot to redeem. Settle these accounts accordingly.

2. Refurnish your credit “room.” This can include refinancing your mortgage while mortgage rates remain low, transferring credit card balances to lower rate alternatives, or utilizing a home equity line that offers a low rate and tax-deductible interest. You will appreciate the new “look” you create. It can be especially pleasing to empty the “room” of some credit commitments by paying them off completely, thus freeing up funds for other expenses.

3. Consider a complete renovation. Is your savings plan sufficient to meet your short- and long-term goals? You may be at a stage in life that requires different tactics.

4. Look at future “housing” needs. What accommodations have you made for your retirement? One of the best savings vehicles in today’s changing world of taxes may be the 401(k) plan, which can reduce taxable income and allow tax deferral on earnings.

5. Solidify your “foundation.” Now may be a good time to review your life insurance policies. The plan you established years ago may need to be updated according to your current needs. Setting up an annual review with your insurance professional can be instrumental in ensuring the adequacy of your coverage.

6. Protect your home. Update your homeowners policy and make a videotape of your home—both inside and out. Be sure to include your valuables. Store the tape in your safe-deposit box, and add to it as the need arises.

7. Dust off your tax records. You never know when the IRS may inquire about your old tax returns, so make sure they are in order. You may also want to speak with your tax professional about any necessary changes to brighten your tax picture before filing your return.

8. Establish a regular “maintenance” program. If you haven’t done so previously, set up a budget. Make “paying yourself first”—putting a set amount into your savings and investments every month—a priority. Analyze your current spending habits, and plan ahead for large bills and expenses.

It is always more relaxing to live in a clean and orderly home. So, take the time now to straighten up your financial house.

How to File an Insurance Claim

Insurance is like a security alarm system. You may sleep better knowing you have it, but you hope it’ll never be activated. If you do need insurance, however, it’s helpful to know what to do.

For a claim under any insurance policy, the first step is to notify your insurance agent that you have experienced a loss. Your agent will tell you what to do next and send along the necessary claim forms to be filled out.

The second step is to fill out those forms and submit them as quickly as possible. In the case of a life insurance claim, you may have to submit the policy document itself, along with the claim form and a death certificate. Insurance companies generally pay claims promptly, but they cannot act until the paperwork is complete. Doing your share will expedite the process.

Although your agent can help you with the details, it will be helpful if you’ve kept policies and any related information close at hand. For example, life insurance policies generally should not be kept in a safe-deposit box. In most states, boxes are temporarily sealed upon the death of the owner. Although an executor can obtain access to the box to locate a will and insurance policies, the need to do so could slow receipt of the funds just when they are needed most. Also, if you own homeowners or renters insurance, keep an updated inventory of your possessions, along with any documentation relating to their worth. This will help you substantiate the value of your belongings in the event of a covered loss.

When dealing with certain types of insurance, such as health or automobile insurance, be aware that some companies pay claims directly, and others only reimburse you after you have paid the bill. Payment procedures are determined by the in-house policy of your insurance company, standard industry practice, or the individual policies of providers in the field.

Policies also frequently require a deductible amount that may result in your receiving an initial bill following a covered loss. Once that amount is satisfied, there may or may not be a co-payment feature under which the insurance company pays a designated percentage of all covered claims, and you are responsible for paying the balance up to a specified amount. See your individual policies for the specific deductible or co-payment amounts that apply to your coverage.

Insurance coverage can help lighten your burden when facing difficult circumstances. You may be able to further ease your mind by fully understanding your insurance policies and the steps you need to take in order to file a claim.

Life Insurance and Your Estate: Adding it All Up

It’s easy to underestimate your net worth. After all, without a crystal ball, the future value of your home and savings is hypothetical. What’s not hypothetical, however, is the fixed amount of the death benefit provided by your life insurance policy. Adding this often significant sum to your asset pool could expose your estate to the Federal estate tax that can run as high as 45% in 2009. Fortunately, there are trusts that can exclude life insurance from an estate.

Many people assume that because death benefit proceeds from a life insurance policy are generally not considered taxable income to the beneficiary, a life insurance policy is beyond the reach of the Internal Revenue Service (IRS). However, when the policy’s death benefits are added to the appreciated value of your home and savings, it may come as a shock to find that the value of your estate may exceed the $3.5 million applicable exclusion amount for 2009.*

Although the unlimited marital deduction allows spouses to transfer assets between them free of estate taxes, nonspousal heirs face the possibility of seeing a life insurance policy inflate an estate’s value above the scheduled exemption amount in the year of death.

One Strategy: A Credit-Shelter Trust

One way to remove the life insurance policy from your estate is to use a type of bypass trust known as a credit-shelter trust. Essentially, a trust is a legal contract between a named donor, a managing trustee, and a beneficiary.

For estate conservation purposes, a trust could be set up to maximize each spouse’s applicable exclusion amount, perhaps sheltering more assets from estate taxation than may be possible through use of the unlimited marital deduction alone. At the death of one spouse, an amount equal to his or her applicable exclusion amount could pass to a trust to benefit the surviving spouse, with the remainder of the assets passing outright to the spouse. Then, at the death of the surviving spouse, assets in the credit shelter trust could be paid to the couple’s children—without being subject to Federal estate tax. Any assets outside the trust upon the surviving spouse’s death, and therefore potentially subject to estate tax, could be further sheltered by the second spouse’s applicable exclusion amount for that year.

Another Approach: An ILIT

When children are the beneficiaries of a life insurance policy and the owner wants to exempt the policy from the estate’s total worth, an irrevocable life insurance trust (ILIT) is another approach. Keep in mind, however, that the term “irrevocable” means beneficiaries may not be changed and loans may not be paid out from the policy once it is put into the trust. Putting a hefty life insurance policy into such a trust could help beneficiaries finance the purchase of a family business or pay estate taxes. However, funding an ILIT may result in gift taxes due.

Park Your Policy in the Right Spot

A trust, depending on the type, can help reduce or defer taxes on high-value assets such as a life insurance policy. More broadly, a trust can be the means to help ensure the policy’s benefits go directly to the intended beneficiary. With the flexibility of trusts, however, comes complexity. Before proceeding, consult with an estate attorney who is experienced in tax matters.

*Unless Congress passes further legislation, the estate tax will be repealed in 2010 for exactly one year. Then, it will be reinstated in 2011 at levels in effect prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).

The information contained in this newsletter is not written or intended as tax, legal, or financial advice and may not be relied on for purposes of avoiding any Federal tax penalties. Entities or persons distributing this information are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.

The information contained in this newsletter is for general use and it is not intended to cover all aspects of a particular matter. While we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different. Therefore, information should be relied upon only when coordinated with professional tax and financial advice. The publisher is not engaged in rendering legal, accounting, or financial advice. Neither the information presented nor any opinion expressed constitutes a representation by us or a solicitation of the purchase or sale of any securities. This newsletter is written and published by Liberty Publishing, Inc., Beverly, MA, COPYRIGHT 2009.



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