Reviewed by Chip Stapleton
Fact checked by Yarilet Perez

The dividend yield tells investors what the simple rate of return is in the form of cash dividends to shareholders. The dividend payout ratio represents how much of a company’s net earnings are paid out as dividends and is an indicator of a company’s ability to distribute dividends consistently in the future.

Key Takeaways

• Analyzing the dividends that companies pay to shareholders helps investors evaluate a firm’s health and share value.
• The dividend yield compares the amount of the dividend paid to the share price of the company’s stock.
• The dividend payout ratio compares the dividend amount to earnings per share.

Dividend Yield

The dividend yield shows how much a company has paid out in dividends over a year. The yield is presented as a percentage, not as an actual dollar amount. This makes it easier to see how much return per dollar invested the shareholder receives through dividends.

For example, a company that pays out $10 in annual dividends per share on a stock trading at $100 per share has a dividend yield of 10%. An increase in share price reduces the dividend yield percentage and vice versa for a price decline.

Dividend Payout Ratio

This financial ratio highlights the relationship between net income and dividend payments to shareholders. The dividend payout ratio is highly connected to a company’s cash flow. Investors can see income and dividend entries on the issuing company’s balance sheet.

The dividend payout ratio shows whether the dividend payments made by a company make sense given their earnings. If the number is too high, it may be a sign that too small a percentage of the company’s profits are reinvested for future operations. This casts doubt on the company’s ability to maintain high dividend payments.

Important

The dividend payout compares how much a company returns to shareholders versus how much it keeps to reinvest, pay off debt, or add to cash reserves.

When Are Dividend Yields Misleading?

Evaluating dividend yields alone can be misleading to investors. Some companies pay out dividends even when they are operating at a short-term loss. Others may pay out dividends too aggressively, failing to reinvest enough capital into their business to maintain profitability down the road. This is where the dividend payout ratio can come in handy.

How Should Investors Compare Dividend Payout Ratios?

When possible, investors should compare dividend payout ratios over some time. It is a sign of good management and financial health if the dividend payout ratios are historically stable or trending upward.

What Is a High Dividend Payout Ratio?

In extreme cases, dividend payout ratios may exceed 100%, meaning more dividends were paid out than there were profits that year. Significantly high ratios are unsustainable. Companies that have stable payout ratios and relatively high dividend yields are usually the most attractive options for investors.

The Bottom Line

The dividend yield percentage shows how much a company has paid out in dividends annually. The dividend payout ratio shows whether the dividend payments make sense given the company’s earnings. Some companies may pay out all earnings to shareholders, some may only pay out a portion, while others don’t pay any dividends to shareholders at all.

Reviewed by Pamela Rodriguez
Fact checked by Suzanne Kvilhaug

What Are Mortgage Points?

Mortgage points are used to offset the costs of mortgage and you can use them in two different ways. Origination points are mortgage points used to pay the lender for the creation of the loan itself, whereas discount points are mortgage points used to buy down the interest rate of the mortgage. Learn more about what mortgage points are and how they work.

Key Takeaways

• There are two kinds of mortgage points: origination points and discount points.
• Buyers pay origination points to the lender as a type of fee for processing the loan.
• Discount points are a way for buyers to lower the interest rate on the loan by paying up front.
• Mortgage points are typically 1% of the loan amount.
• You can use the annual percentage rate (APR) to compare the cost of loans with different points and interest rates.

How Mortgage Points Work

Mortgage points come in two types: origination points and discount points. In both cases, each point is typically equal to 1% of the total amount mortgaged. On a $300,000 home loan, for example, one point is equal to $3,000.

Both types of points are included under closing costs in the official loan estimate and closing disclosure that come from the lender.

Origination Points

Origination points compensate loan officers. Not all mortgage providers require the payment of origination points, and those that do are often willing to negotiate the fee. Origination points are not tax deductible and many lenders have shifted away from origination points, with several offering flat-fee or no-fee mortgages.

Discount Points

Discount points are prepaid interest. The purchase of each point generally lowers the interest rate on your mortgage by up to 0.25%. Most lenders provide the opportunity to purchase anywhere from a fraction of a point to three discount points.

Prior to the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, which applies to tax years 2018 to 2025, origination points were not tax deductible, but discount points could be deducted on Schedule A.

Going forward, discount points are deductible but limited to the first $750,000 of a loan. In addition, there is a higher standard deduction, so it’s advisable to check with a tax accountant to find out if you could receive tax benefits from purchasing points.

Keep in mind that when lenders advertise rates, they may show a rate that is based on the purchase of points.

Calculating Mortgage Discount Points

There are two primary factors to weigh when considering whether or not to pay for discount points.

The first factor involves the length of time that you expect to live in the house. In general, the longer you plan to stay, the bigger your savings if you purchase discount points.

The second factor to consider is whether or not you have enough money to pay for the cost of mortgage points. Many people are barely able to afford the down payment and closing costs on their home purchases, and there simply isn’t enough money left to purchase points.

For instance, on a $100,000 home, three discount points are relatively affordable at $3,000, but on a $500,000 home, three points will cost $15,000. On top of the traditional 20% down payment of $100,000 for that $500,000 home, another $15,000 may be more than the buyer can afford.

A mortgage calculator is a good resource to help you budget these costs.

Example of Paying Discount Points

Consider the following example for a 30-year loan:

• On a $100,000 mortgage with an interest rate of 3%, your monthly payment for principal and interest would be $421 per month.
• If you purchase three discount points, your interest rate might be 2.25%, which puts your monthly payment at $382 per month.

Purchasing the three discount points would cost you $3,000 in exchange for a savings of $39 per month. You would need to keep the house for 72 months, or six years, to break even on the point purchase. Because a 30-year loan lasts 360 months, purchasing points would be a wise move in this instance if you plan to live in your new home for a long time.

If, on the other hand, you plan to stay for only a few years, you may wish to purchase fewer points or none at all. There are numerous calculators available that can assist you in determining the appropriate amount of discount points to purchase based on the length of time you plan to own the home.

Using APR to Compare Loans

Comparing different lenders and loans with varying interest rates, lender fees, origination fees, discount points, and origination points can be very difficult. The annual percentage rate (APR) figure on each loan estimate helps make it easier for borrowers to compare loans, which is why mortgage lenders are required by law to include it on all loans.

The APR on each loan adjusts the advertised interest rate on the loan to include all discount points, fees, origination points, and any other closing costs for the loan. This metric exists to make comparison easier between loans with wildly different discount points, interest rates, and origination fees.

Are Mortgage Points Worth It?

Though money paid on discount points could be invested in the stock market to generate a higher return than the amount saved by paying for the points, the average homeowner’s fear of getting into a mortgage they can’t afford can outweigh the potential benefit they may accrue if they managed to select the right investment. In many cases, paying off the mortgage is more important.

Also, keep in mind the motivation behind purchasing a home. Though most people hope to see their residence increase in value, few people purchase their home strictly as an investment. From an investment perspective, if your home triples in value, you may be unlikely to sell it for the simple reason that you then would need to find somewhere else to live.

If your home gains in value, it is likely that most of the other homes in your area will increase in value as well. If that is the case, selling your home will give you only enough money to purchase another home for nearly the same price. Also, if you take the full 30 years to pay off your mortgage, you will likely have paid nearly triple the home’s original selling price in principal and interest costs and, therefore, you won’t make much in the way of real profit if you sell at the higher price.

How Much is One Point Worth In a Mortgage?

A mortgage point is a fee paid to the lender to lower the interest rate on a mortgage. One point is equivalent to 1% of the total loan. As an example, if your loan is for $250,000, one point is $2500.

How Much Does One Point Affect the Mortgage Payment?

One point, which is usually equivalent to one percent of the total loan amount, lowers the interest rate by about 0.25%, which might equate to several dollars per month, or more, depending on the loan size.

What Do Discount Points Cost?

Discount points cost roughly 1% of the loan amount per point. So if you had a mortgage of $350,000, one discount point would be $3,500. In return, the lender reduces the interest rate, usually by 0.25% although the amount varies.

The Bottom Line

Origination points are usually avoidable and negotiable so don’t spend too much on them. Discount points, on the other hand, can save you money over the life of the loan, but only if you can afford to buy them without lowering your down payment below 20% and having to get private mortgage insurance (PMI).

Fact checked by Marcus Reeves
Reviewed by Natalya Yashina

A gearing ratio measures a company’s overall debt against its value. To stock analysts, investors, and lenders, the gearing ratio is an indicator of the company’s financial fitness. A company may be carrying too much debt or too little debt. The amount of debt that is perceived as healthy varies by industry.

Generally, a company that has a larger portion of debt in comparison to its shareholder equity has a high gearing ratio. A company that has a small proportion of debt versus equity has a low gearing ratio.

Key Takeaways

• There are several types of net gearing ratios but all compare company equity (or capital) to company debt.
• Net gearing is the most common type of gearing ratio and is calculated by dividing the company’s total debt by its total shareholders’ equity.
• The optimal gearing ratio depends on the industry.

Gearing Ratios: An Overview

The gearing ratio tells you how much of a company’s operations is funded by equity and how much is funded by debt.

Lenders use gearing ratios when they’re considering making loans. Corporate managers use them to make decisions about their use of cash and leverage. Here’s how these ratios are interpreted:

• High Gearing Ratio: The company has a larger proportion of debt versus equity
• Low Gearing Ratio: The company has a small proportion of debt versus equity

There are several variations of the gearing ratio. They include the equity ratio, debt-to-capital ratio, debt service ratio, and net gearing ratio. Each is calculated using a different formula.

Important

High net gearing ratios can be a red flag. But they are more acceptable in certain industries. Businesses that need to invest heavily in property or manufacturing equipment often have relatively high debt.

The Most Common: Net Gearing Ratio

The net gearing ratio measures the level of a company’s overall debt compared to its value. It is the most commonly used gearing ratio in the financial markets. Most investors know it as the company’s debt-to-equity (D/E) ratio.

The D/E ratio measures how much a company is funded by debt versus how much is financed by equity. It compares a company’s total debt obligations to its shareholder equity.

The debt portion in the net gearing ratio may include the following:

• Short-term debt
• Long-term debt
• Accrued debt
• Accounts payable (AP)
• Financing agreements
• Leases

It’s important to compare the net gearing ratios of competing companies—that is, companies that operate within the same industry. Every industry has its own capital needs and relies on different growth rates.

How to Calculate the Net Gearing Ratio

The net gearing ratio (as a debt-to-equity ratio) is calculated by:

$begin{aligned} &text{Net Gearing Ratio} = frac { text{LTD} + text{STD} + text{Bank Overdrafts} }{ text{Shareholders’ Equity} } \ &textbf{where:} \ &text{LTD} = text{Long-Term Debt} \ &text{STD} = text{Short-Term Debt} \ end{aligned}$​Net Gearing Ratio=Shareholders’ EquityLTD+STD+Bank Overdrafts​where:LTD=Long-Term DebtSTD=Short-Term Debt​

Net gearing can also be calculated by dividing the total debt by the total shareholders’ equity. The ratio, expressed as a percentage, reflects the amount of existing equity that would be required to pay off all outstanding debts.

Note

Capital gearing is a British term that refers to the amount of debt a company has relative to its equity. In the U.S., capital gearing is known as financial leverage and is synonymous with the net gearing ratio.

Good and Bad Gearing Ratios

An optimal gearing ratio is primarily determined by the individual company relative to other companies within the same industry. There are, however, a few basic rules for good and bad gearing ratios:

• Higher Than 50%: A gearing ratio in this range indicates the company is highly leveraged. The company would be seen as being at greater financial risk because it is more susceptible to default and bankruptcy during times of lower profits or higher interest rates.
• Between 25% and 50%: A gearing ratio within this range is typically considered optimal or normal for well-established companies.
• Lower Than 25%: Gearing ratios that fall under this value are typically considered low-risk by both investors and lenders.

Gearing Ratios and Risk

The gearing ratio is an indicator of the financial risk associated with a company. If a company has too much debt, it has the potential to fall into financial distress. Remember: A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite.

Capital that is borrowed is riskier than capital from the company’s owners since creditors have to be paid back even if the business doesn’t generate income. A company with too much debt might be at risk of default or bankruptcy, especially if the loans have variable interest rates. 

On the plus side, debt helps a company expand its operations, add new products and services, and ultimately boost profits. A company that never borrows might be missing out on opportunities, especially when loan interest rates are low.

Capital-intensive companies and those with a lot of fixed assets, like industrials, are likely to have more debt versus companies with fewer fixed assets. For example, utility companies typically have high gearing ratios. This is acceptable because these companies operate as regulated monopolies in their markets, which makes their debt less risky than companies in competitive markets.

Why Are Gearing Ratios Important?

Gearing ratios indicate the degree to which a company’s operations are funded by its debt versus its equity. High ratios relative to their competitors can be a red flag while low ratios generally indicate that a company is low-risk.

What Does the Net Gearing Ratio Tell You?

The net gearing ratio is the most common gearing ratio used by analysts, lenders, and investors. Also called the debt-to-equity ratio, it measures how much of the company’s operations are funded by debt compared to its equity.

Is it Better to Have a High Gearing Ratio?

A high gearing ratio can be a blessing or a curse—depending on the company and industry. Having a high gearing ratio means that a company is using more debt to fund its operations, which may increase the financial risk. But, high ratios work well for certain companies, especially if they are in capital-intensive industries. It shows they are investing in growth.

The Bottom Line

A safe gearing ratio can vary by company and is largely determined by how a company’s debt is managed and how well the company is performing. The gearing ratio must be viewed alongside other major numbers such as earnings growth, market share, and cash flow. 

It’s also worth considering that well-established companies could pay off their debt by issuing equity if needed. In other words, having debt on the balance sheet might be a strategic business decision since it might mean less equity financing. Fewer shares outstanding can mean a higher stock price. 

Reviewed by Thomas Brock

Preference Shares vs. Bonds: An Overview

Although holders of preference shares and bonds are both entitled to regular distribution payments, preference shares do not have a maturity date and can continue in perpetuity. Bondholders are entitled to the receipt of regular interest rate payments, while holders of preference shares receive regular dividend payments.

Key Takeaways

• A bond is a fixed income instrument that represents a loan made by an investor to a borrower.
• Preference shares are shares of a company’s stock with dividends that are paid out.
• Bonds often have a maturity date, while preference shares do not.
• Bondholders have a higher chance of being paid in bankruptcy versus holders of preference shares.

Bonds

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). Bondholders are creditors of the company, having loaned it money.

A bond has an end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments that will be made by the borrower. 

Bonds have a fixed maturity and ultimately expire, limiting the amount of interest paid out.

Bondholders, as creditors of the company, have a higher chance of being paid versus holders of preference shares, depending on the priority of the debt. Bonds may be secured by assets of the company. The principal can be paid back to the bondholder by the sale of those assets in case of a bankruptcy. Unsecured bonds are not backed by any assets of the company and have a lower likelihood of receiving any distributions.

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date.

Preference Shares

Holders of preference shares own a piece of the company. Preference shares, more commonly referred to as preferred stock, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders.

Most preference shares have a fixed dividend, while common stocks generally do not. Preferred stock shareholders also typically do not hold any voting rights, but common shareholders usually do. Unlike bond payments, which are mandatory, holders of preference shares may miss some dividend payments if the company does not make a profit. If the preference shares are cumulative, the investor is entitled to receive payment for missed dividends prior to any dividends being paid to common shareholders.

Preference shares continue as long as the company is in business, or, for redeemable stock, until the company decides to buy it back.

In the case of bankruptcy or dissolution, holders of preference shares have a higher priority over common shareholders in being paid off when the company’s assets are liquidated. As a practical matter, preference shareholders are unlikely to receive any money during a bankruptcy dissolution, as they are fairly low on the priority list for repayment.

Preference shares fall under four categories: cumulative preferred stock, non-cumulative preferred stock, participating preferred stock, and convertible preferred stock.

Note

Preference shares do not come with voting rights.

Key Differences

The main difference between preference shares and bonds is that shares represent ownership of the company, while bonds simply represent a loan obligation. If the company is dissolved, bondholders are among the first in line to get a payout of the remaining assets. Preferred shareholders are further back in line, and less likely to recoup their full investment.

There are also structural differences. A typical bond pays out a fixed coupon at regular intervals, until the maturity date when the entire principal is returned to the investor. A preferred share has no maturity date: It continues paying dividends for the lifetime of the company

What Is the Difference Between Preferred Stock and Common Stock?

Preferred shares are a type of ownership share that receives a higher dividend than common stock, although they do not confer voting rights. In the event that the company dissolves, preferred shareholders have preference over common shareholders, meaning that they are more likely to recoup part of their investment.

What Are the Downsides to Preferred Stock?

Preferred shares tend to have lower liquidity than common shares, meaning that they are harder to sell at market price. In addition, they do not confer voting rights.

How Do You Convert Preferred Stock?

Some preferred shares are convertible, meaning that they can be exchanged for common shares at a fixed price and ratio. The exact terms for conversion will be spelled out in the issuance documents for the preferred stock. If the company is successful, investors can benefit from exchanging the stability of their preferred shares for the higher gains of the common shares.

The Bottom Line

Preferred stock is a type of ownership share that comes with a fixed dividend, giving it some similarities to a bond. However, bondholders have a higher priority for repayment if the company dissolves. Preferred shareholders receive a higher dividend than owners of common stock, although they do not have voting rights.

Reviewed by Robert C. Kelly
Fact checked by Amanda Bellucco-Chatham

It’s 1974. The inflation rate hit double digits in February of 1974 and would stay in double digits until May 1975.

Not much was looking any better. The stock market lost about a third of its value from the beginning of the decade to late 1974. In that same year, the unemployment rate was above 7%.

The easy money policies of the Federal Reserve were meant to generate full employment by the early 1970s. Instead, they caused inflation to soar.

Under new leadership, the central bank reversed its policies, raising interest rates steadily. Mortgage rates would climb to double digits by 1978 and kept climbing before peaking at 18.45% in 1981.

Key Takeaways

• Rapid inflation occurs when the prices of goods and services suddenly rise, eroding the purchasing power of consumers.
• The 1970s saw some of the highest rates of inflation in modern U.S. history.
• In turn, mortgage interest rates rose to nearly 20%.
• Fed policy, the abandonment of the gold standard, Keynesian economic policies, and market psychology all contributed to high inflation.
• Lower inflation would return only after a tough period of tight money and recession.

The Great Inflation of the 1970s

Overall, the macroeconomic event known as the Great Inflation stretched from 1965 to 1982. That means the economic disruption started during the era of President Lyndon B. Johnson and continued through the presidencies of Richard Nixon, Gerald Ford, and Jimmy Carter.

The most painful period began in late 1972 and continued into the early 1980s.

In his book, Stocks for the Long Run: A Guide for Long-Term Growth, Wharton professor Jeremy Siegel called this time “the greatest failure of American macroeconomic policy in the postwar period.”

Spreading the Blame

The Great Inflation was variously blamed on oil price manipulation by OPEC, currency speculators, greedy businessmen, and avaricious union leaders.

However, monetary policies that financed massive federal budget deficits deserve much of the blame. As economist Milton Friedman wrote in his book, Money Mischief: Episodes in Monetary History. inflation is always “a monetary phenomenon.”

The Great Inflation and the recession that followed ruined many businesses and hurt countless individuals. Interestingly, John Connally, the Nixon-installed Treasury Secretary with no formal economics training, later declared personal bankruptcy.

Yet these unusually bad economic times were preceded by a period in which the economy boomed or appeared to boom. Many Americans were awed by the temporarily low unemployment and strong growth numbers of 1972.

In 1972, they overwhelmingly re-elected a Republican president, Richard Nixon, and a Congress controlled by Democrats.

Causes of the Great Inflation

Upon his inauguration in 1969, Nixon inherited a recession from Lyndon Johnson, who had spent generously on the social programs of the Great Society and the Vietnam War.

Despite some protests, Congress went along with Nixon and continued to fund the war and increase social welfare spending. In 1972, for example, Congress and Nixon agreed to a big expansion of Social Security—just in time for the elections.

Nixon’s Changing Viewpoint

Nixon came to office as a supposed fiscal conservative. However, he ran up the budget deficit and eventually declared that he was a Keynesian. John Maynard Keynes was an influential economist of the 1930s and 1940s who advocated countercyclical policies in hard times, running deficits in recessions to pump money into the economy.

Before Keynes, governments had met recessionary times with balanced budgets and waited for businesses to adjust or liquidate. The object was to allow market forces to bring about a recovery without government intervention.

Nixon’s other economic about-face occurred when he imposed wage and price controls in 1971. They were a short-term success politically. Later, they would fuel the fires of double-digit inflation because, once they were removed, businesses boosted prices to recover lost ground.

Nixon’s deficits also made dollar-holders abroad nervous. There was a run on the dollar, which many foreigners and Americans thought was overvalued. Soon they were proved right.

In 1971, Nixon broke the last link to the gold standard, turning the American dollar into a fiat currency. The dollar was devalued and millions of foreigners holding dollars, including oil barons in the Middle East with tens of millions of petrodollars, saw their wealth fall. 

Election Year Politics

Still, President Nixon’s primary concern was not the U.S. dollar, or deficits, or even inflation. He feared another recession.

He and others who were running for re-election wanted the economy to boom. The way to do that, Nixon reasoned, was to pressure the Fed to lower interest rates.

Nixon fired Fed chair William McChesney Martin and installed presidential counselor Arthur Burns as his successor in early 1970.

Nixon wanted cheap money. That meant low interest rates to promote growth in the short term and make the economy seem strong as voters went to cast their ballots.

Note

Richard Nixon was forced to resign from the presidency in August 1974, as a result of the infamous Watergate scandal. His successor, then-Vice President Gerald Ford, would lose the next presidential election to Democrat Jimmy Carter.

The Politics of Cheap Money

In public and private, Nixon put the pressure on Burns. William Greider, in his book, Secrets of the Temple: How the Federal Reserve Runs The Country, Nixon is quoted as saying, “We’ll take inflation if necessary, but we can’t take unemployment.”

The nation got an abundance of both.

The key money creation number, M1, calculates the total cash in circulation at a given time. It grew from $228 billion to $249 billion between December 1971 and December 1972, according to Federal Reserve Board numbers. As a matter of comparison, in Fed chair Martin’s last year, M1 grew from $198 billion to $206 billion. M2, which measures retail savings and small deposits, grew even more by the end of 1972, from $710 billion to $802 billion.

Adding to the money supply worked in the short term. Nixon carried 49 out of 50 states in the election. Democrats easily held Congress. Inflation was in the low single digits.

However, the country paid the price in higher inflation once the election year festivities ended.

In the winters of 1972 and 1973, Burns began to worry about inflation. In 1973, inflation more than doubled to 8.8%. Later in the decade, it would go to 12%. By 1980, inflation was at 14%.

Was the United States about to become another Weimar Republic experiencing the brutal effects of crippling inflation?

The Great Inflation period would finally come to an end once later Fed chair Paul Volcker pursued a bold but painful contractionary money policy to control it.

What Is Inflation?

Prices for individual products fluctuate up and down constantly, but a continuing increase in the prices of a broad group of essential goods and services results in inflation.

When inflation occurs, consumers get less for every dollar they spend. Effectively, their income has decreased.

What Was the Great Inflation of the 1970s?

The period in the 1970s and extending into the early 1980s was a time of relentless inflation. The inflation rate, as measured by the Consumer Price Index, rose to as high as 14% in 1980.

Federal Reserve policy that promoted a large increase in the money supply is considered the main reason for the Great Inflation.

How Did the Great Inflation Affect Americans?

The steady and lasting rise in prices seen during the Great Inflation created a time of tremendous financial pressure for most Americans.

People found it difficult make ends meet. They worried about depleting their savings to cover the gap between their income and their expenses. They had to make unpleasant choices about which items to buy.

The deeply unsettling effect of inflation eroded their standard of living and their confidence in the country’s leadership.

The Bottom Line

It would take another Fed chair and a brutal policy of tight money—including the acceptance of a recession—before inflation would return to low single digits.

In the meantime, workers would endure jobless numbers that exceeded 10%. Millions of Americans were suffering from day to day by the late 1970s and early 1980s.

Few remember Fed chair Burns, who in his memoirs, Reflections of an Economic Policy Maker (1969-1978), blames others for the Great Inflation without mentioning the disastrous monetary expansion. Nixon didn’t even mention this central bank episode in his memoirs. Many who remember this terrible era blame it on the Arab oil-producers for manipulating the global oil supply.

Still, The Wall Street Journal, when reviewing this period in January 1986 wrote, “OPEC got all the credit for what the U.S. had mainly done to itself.”

Fact checked by Skylar Clarine
Reviewed by Doretha Clemon

Loan Officer vs. Mortgage Broker: An Overview

Borrowers commonly have two options for securing a mortgage: a loan officer or a mortgage broker. Both prepare loan applications and process them, but their methods vary.

A loan officer works for a bank, a credit union, or a mortgage lender and generally offers only the programs and mortgage rates available from that institution. A mortgage broker works on a borrower’s behalf to find the best rate and loan from various institutions.

Key Takeaways

• Loan officers work for mortgage lenders such as banks or other financial institutions.
• Mortgage brokers are independent and can recommend the best fit for the borrower’s needs from many institutions.
• A loan officer commonly works on commission.

Loan Officer

Loan officers represent the mortgage lender they work for and help borrowers apply for loans offered by the financial institution. They are knowledgeable about lending products, banking industry rules and regulations, and the required loan documentation to advise their clients.

Loan officers help guide borrowers based on their financial circumstances and assist with the mortgage process. They work with the lender’s underwriter, who reviews the applicant’s creditworthiness and ability to pay the loan. When the loan is approved, the loan officer prepares the mortgage closing documents.

Some loan officers are compensated through commissions. This commission is a prepaid charge and is often negotiable. Commission fees are usually higher for mortgage loans than other types of loans. Large banks commonly work exclusively through their loan officers, and an independent mortgage broker will not offer their products.

Important

Loan officers work for just one financial institution and can only offer loans from their employer. A borrower’s options are limited to the company offerings.

Mortgage Broker

Mortgage brokers represent more than one lender and work with a variety of financial institutions such as banks, credit unions, and mortgage lenders. A mortgage broker acts as a matchmaker to find the best mortgage product for the borrower’s financial situation and connect applicants with the right lenders.

The mortgage broker may gather paperwork from the borrower and pass it along to a mortgage lender for underwriting and approval. Some lenders work exclusively with mortgage brokers, providing borrowers access to loans that otherwise would not be available to them. Brokers may negotiate with lenders to waive application, appraisal, origination, and other fees.

The number of lenders that a broker can access is limited to the institutions that have approved their services. Mortgage brokers earn a commission from the borrower, the lender, or both. These commissions, known as origination fees, are commonly 1% to 2% of the loan amount. Mortgage brokers must be licensed and must disclose their fees upfront.

Key Differences

When borrowers work with a loan officer, they deal directly with the institution that will lend them money. When borrowers work with a mortgage broker, they work with a third party. The broker merely facilitates the process between the borrower and the lender.

Loan officers can only offer loans from their employers. Mortgage brokers deal with many lenders and may be able to find a range of options for their clients.

Whether using a broker or a loan officer, borrowers can find out what fees they’re paying on the loan estimate that they receive when applying for the mortgage, commonly found under “Origination Charges.”

What Is the Benefit of Using a Loan Officer?

There are advantages to applying directly through a loan officer. Because the loan will be considered “in-house,” borrowers may get a break on their rates and closing costs and may have access to any down payment assistance (DPA) programs for which they’re eligible.

What Is a Mortgage Loan Originator?

Mortgage brokers and loan officers are considered mortgage loan originators (MLOs) and meet strict federal requirements to help negotiate mortgage loans.

Why Use a Mortgage Broker Instead of a Bank?

A bank’s loan officers can only recommend their bank’s products. Mortgage brokers work with many lenders and might be able to find a better deal for each borrower.

The Bottom Line

Whether borrowers work with a loan officer or a mortgage broker, they should pay careful attention to the fees and commissions charged. Consumers can also research loan products before choosing a lender and representative.

Reviewed by Samantha Silberstein

What are some things that separate a good trader from a great one? Guts, instincts, intelligence, and, most importantly, timing. Just as there are many types of traders, there is an equal number of different time frames for traders to develop their ideas and execute their strategies.

At the same time, timing also helps market warriors account for factors outside of their control. They can include position leveraging, nuances of different currency pairs, and the effects of scheduled and unscheduled news releases in the market. Timing is always a major consideration when participating in the foreign exchange world.

Want to bring your trading skills to the next level? Read on to learn more about time frames and how to use them to your advantage.

Key Takeaways

• There are different forex trading strategies for each time horizon.
• Day traders seek to profit from small changes in the intraday market.
• Swing traders seek to hold a position for hours or days, anticipating a turn in the market.
• Position traders have the most long-term outlook, and examine government decisions and interest rates to forecast price changes.
• Forex traders should also pay attention to news and interest rates when assessing the market.

Common Trader Time Frames

In the grander scheme of things, there are plenty of names and designations that traders go by. But when taking time into consideration, traders and strategies tend to fall into three broader and more common categories: day trader, swing trader, and position trader.

1. The Day Trader

Let’s begin with what seems to be the most appealing of the three designations, the day trader. A day trader will, for a lack of a better definition, trade for the day. These are market participants that will usually avoid holding anything after the session close and will trade in a high-volume fashion.

On a typical day, this short-term trader will generally aim for a quick turnover rate on one or more trades, anywhere from 10- to 100-times the normal transaction size. This is in order to capture more profit from a rather small swing. As a result, traders who work in proprietary shops in this fashion will tend to use shorter time-frame charts, using one-, five-, or 15-minute periods. In addition, day traders tend to rely more on technical trading patterns and volatile pairs to make their profits. Although a long-term fundamental bias can be helpful, these professionals are looking for opportunities in the short term.

One such currency pair is the British pound/Japanese yen as shown in Figure 1, above. This pair is considered to be extremely volatile, and is great for short-term traders, as average hourly ranges can be as high as 100 pips. This fact overshadows the 10- to 20-pip ranges in slower moving currency pairs like the euro/U.S. dollar or euro/British pound.

2. Swing Trader

Taking advantage of a longer time frame, the swing trader will sometimes hold positions for a couple of hours—maybe even days or longer—in order to call a turn in the market. Unlike a day trader, the swing trader is looking to profit from an entry into the market, hoping the change in direction will help their position. In this respect, timing is more important in a swing trader’s strategy compared to a day trader.

However, both traders share the same preference for technical over fundamental analysis. A savvy swing trade will likely take place in a more liquid currency pair like the British pound/U.S. dollar. In the example below (Figure 2), notice how a swing trader would be able to capitalize on the double bottom that followed a precipitous drop in the GBP/USD currency pair. The entry would be placed on a test of support, helping the swing trader to capitalize on a shift in directional trend, netting a two-day profit of 1,400 pips.

3. The Position Trader

Usually the longest time frame of the three, the position trader differs mainly in their perspective of the market. Instead of monitoring short-term market movements like the day and swing style, these traders tend to look at a longer term plan. Position strategies span days, weeks, months or even years. As a result, traders will look at technical formations but will more than likely adhere strictly to longer term fundamental models and opportunities. These FX portfolio managers will analyze and consider economic models, governmental decisions and interest rates to make trading decisions. The wide array of considerations will place the position trade in any of the major currencies that are considered liquid. This includes many of the G7 currencies as well as the emerging market favorites.

Additional Considerations

With three different categories of traders, there are also several different factors within these categories that contribute to success. Just knowing the time frame isn’t enough. Every trader needs to understand some basic considerations that affect traders on an individual level.

Leverage

Widely considered a double-edged sword, leverage is a day trader’s best friend. With the relatively small fluctuations that the currency market offers, a trader without leverage is like a fisherman without a fishing pole. In other words, without the proper tools, a professional is left unable to capitalize on a given opportunity. As a result, a day trader will always consider how much leverage or risk they are willing to take on before transacting in any trade.

Similarly, a swing trader may also think about their risk parameters. Although their positions are sometimes meant for longer term fluctuations, in some situations, the swing trader will have to feel some pain before making any gain on a position. In the example below (Figure 3), notice how there are several points in the downtrend where a swing trader could have capitalized on the Australian dollar/U.S. dollar currency pair. Adding the slow stochastic oscillator, a swing strategy would have attempted to enter into the market at points surrounding each golden cross.

However, over the span of two to three days, the trader would have had to withstand some losses before the actual market turn could be called correctly. Magnify these losses with leverage and the final profit/loss would be disastrous without proper risk assessment.

Different Currency Pairs

In addition to leverage, currency pair volatility should also be considered. It’s one thing to know how much you may potentially lose per trade, but it’s just as important to know how fast your trade can lose. As a result, different time frames will call for different currency pairs. Knowing that the British pound/Japanese yen currency cross sometimes fluctuates 100 pips in an hour may be a great challenge for day traders, but it may not make sense for the swing trader who is trying to take advantage of a change in market direction. For this reason alone, swing traders will want to follow more widely recognized G7 major pairs as they tend to be more liquid than emerging market and cross currencies. For example, the euro/U.S. dollar is preferred over the Australian dollar/Japanese yen for this reason.

News Releases

Finally, traders in all three categories must always be aware of both unscheduled and scheduled news releases and how they affect the market. Whether these releases are economic announcements, central bank press conferences, or the occasional surprise rate decision, traders in all three categories will have individual adjustments to make.

Short-term traders will tend to be the most affected, as losses can be exacerbated while swing trader directional bias will be corrupted. To this effect, some in the market will prefer the comfort of being a position trader. With a longer-term perspective, and hopefully a more comprehensive portfolio, the position trader is somewhat filtered by these occurrences as they have already anticipated the temporary price disruption. As long as the price continues to conform to the longer-term view, position traders are rather shielded as they look ahead to their benchmark targets.

A great example of this can be seen on the first Friday of every month in the U.S. non-farm payrolls report. Although short-term players have to deal with choppy and rather volatile trading following each release, the longer-term position player remains relatively sheltered as long as the longer-term bias remains unchanged.

Which Time Frame Is Right?

Which time frame is right really depends on the trader. Do you thrive in volatile currency pairs? Or do you have other commitments and prefer the sheltered, long-term profitability of a position trade? Fortunately, you don’t have to be pigeon-holed into one category. Let’s take a look at how different time frames can be combined to produce a profitable market position.

Warning

Forex markets are more volatile than equities markets. This can be a potential source of profit, but it also comes with higher risks.

Like a Position Trader

As a position trader, the first thing to analyze is the economy—in this case, in the U.K. Let’s assume that given global conditions, the U.K.’s economy will continue to show weakness in line with other countries. Manufacturing is on the downtrend with industrial production as consumer sentiment and spending continue to tick lower. Worsening the situation has been the fact that policymakers continue to use benchmark interest rates to boost liquidity and consumption, which causes the currency to sell off because lower interest rates mean cheaper money.

Technically, the longer term picture also looks distressing against the U.S. dollar. Figure 5 shows two death crosses in our oscillators, combined with significant resistance that has already been tested and failed to offer a bearish signal.

Like a Day Trader

After we establish the long-term trend, which in this case would be a continued deleveraging, or sell off, of the British pound, we isolate intraday opportunities that give us the ability to sell into this trend through simple technical analysis (support and resistance). A good strategy for this would be to look for great short opportunities at the London open after the price action has ranged from the Asian session.

Although too easy to believe, this process is widely overlooked for more complex strategies. Traders tend to analyze the longer term picture without assessing their risk when entering into the market, thus taking on more losses than they should. Bringing the action to the short-term charts helps us to see not only what is happening, but also to minimize longer and unnecessary drawdowns.

How Do You Get Started Day Trading?

The first step to day trading is to learn some of the beginner day trading strategies, while acquainting yourself with the rules and regulations of the market. It also helps to try paper trading to test your knowledge of these trading strategies. When you are ready, find an appropriate trading platform and begin trading with an amount of capital that you would feel comfortable about losing.

What Are the Risks of Day Trading in the Forex Market?

Forex traders typically need to borrow large amounts of money on margin in order to make profitable trades. While the stock market has a maximum margin requirement of 50%, margins in forex markets can be as low as 1%. This means that a tiny adverse movement in the market could be enough to wipe out your entire position.

How Do Forex Traders Make Money?

Forex traders speculate on the relative prices of major global currencies with respect to one another. In addition to betting on spot rates, they can also profit from the relative interest rates of different currencies. For example, traders may sell a currency with a low interest rate to buy one with a higher interest rate, thereby profiting from the difference.

The Bottom Line

Time frames are extremely important to any trader. Whether you’re a day, swing, or even position trader, time frames are always a critical consideration in an individual’s strategy and its implementation. Given its considerations and precautions, the knowledge of time in trading and execution can help every novice trader head toward greatness.

The process is relatively simple, but watch out for prepayment penalties

Fact checked by Timothy Li
Reviewed by Doretha Clemon

You can refinance a home equity loan just as you would a regular mortgage. But there are some special considerations to think about before you proceed. You might want to refinance a home equity loan if interest rates have dropped, a different repayment term would suit you better, or you need more money but don’t wish to repay two home equity loans at the same time. Before you refinance, it helps to determine how much equity you currently have in your home. You’ll also want to determine if there are prepayment penalties before refinancing.

Key Takeaways

• You might want to refinance your home equity loan if you can get a substantially better interest rate on a new one.
• Before you refinance, check to see if your loan imposes a prepayment penalty for ending it ahead of schedule.
• One alternative to refinancing a home equity loan is to refinance your main mortgage with a cash-out refinance.

How Refinancing Works

When you refinance a home loan—whether it’s your principal mortgage or a home equity loan—you take out a new loan for at least enough money to pay off the old one. After that, you make payments on the new loan. At some point, you might even refinance the new loan by taking out yet another one.

Why would you want to refinance a loan? A common reason is that you can get a lower interest rate and reduce your payments. Another is to obtain a loan with different terms—for example, switching from a 30-year mortgage to a 15-year one or vice versa.

Refinancing is rarely free, however. You are likely to face closing costs and other fees, just as you did with the earlier loan. Therefore, it’s important to consider how much you’ll save by refinancing vs. how much you’ll have to pay upfront to do so. For example, if you can save $200 a month by refinancing, but your closing costs add up to $5,000, it will take you 25 months to break even.

Refinancing also requires some work on your part, such as rounding up all the documentation that a lender may ask you to supply. If you value your time, you might also want to think twice.

Refinancing a Home Equity Loan

As with a regular mortgage, there are several reasons why you might consider refinancing an existing home equity loan. One is if interest rates have fallen substantially since you took out your loan. Another is if you would prefer a different term or repayment period. For example, you might have a home equity loan that has to be paid off in five years, but you would rather stretch your payments over 10 or 15 years. Another is if you need to borrow additional money but don’t want to make payments on two home equity loans at the same time.

You can refinance your home equity loan at the bank, credit union, or other financial institution that issued your current one or with another lender. You might want to start with your current lender, which has an incentive to keep your business after you’ve paid off the old loan and may be more open to negotiating with you.

Before you commit yourself to refinancing, check to see whether your current home equity loan imposes a penalty for paying it back early. If it does have a prepayment penalty, you’ll need to assess whether it would make more sense to simply ride out the old loan until the end of its term, even if its interest rate is higher than you could get on a new one.

Note

Under current tax laws, the interest on a home equity loan is deductible only if it’s used “to buy, build, or substantially improve the taxpayer’s home that secures the loan,” the Internal Revenue Service says.

What to Expect When You Refinance a Home Equity Loan

As with your current home equity loan, you’ll need to prove to the lender that you have enough equity in your home and that you’re a good risk. If neither of those has changed for the worse since you got your original loan, you should be OK, but you still may have to provide a lot of documentation.

Lenders typically use what’s known as a combined loan-to-value (CLTV) ratio to determine whether to offer you a home equity loan and, if so, for how much. The CLTV ratio takes into account all of the outstanding debt you have on the property, including the first mortgage, as well as what the property is currently worth. For example, a lender might balk at issuing a new loan if those debts in total would exceed 80% of your home’s value. To verify your home’s value, the lender will usually bring in a professional appraiser.

In addition to your home, the lender will want information about you. To assure itself that you’ll have the means to repay the loan, the lender will likely request an assortment of documents, including your pay stubs, W-2 forms, recent tax returns, bank statements, and 1099-DIVs reporting your investment income.

To check on your creditworthiness, the lender will most likely pull your credit reports from one or more of the three major national credit bureaus and look up your credit score. Typically, you’ll need a FICO score of at least 680 to qualify, according to Experian, one of the bureaus.

Before you even apply, you might want to check your credit reports for accuracy. You can obtain free copies more or less instantly from each of the three major credit bureaus on AnnualCreditReport.com, the official website for that purpose. If you find any inaccurate negative information, you can challenge it with the credit bureau. Your credit score is not included on your credit reports, but there are also ways to obtain your credit score free of charge. 

One Alternative to Consider: Cash-Out Refinancing 

Depending on your goals in refinancing your current home equity loan, you might consider a cash-out refinance instead. In a cash-out refinance, you take out a new mortgage large enough to pay off your old mortgage and provide you with a lump sum in cash. You could use some of that cash to pay off your existing home equity loan and the rest for other purposes. This way, you would have just one loan to repay, and rather than needing to pay some of it back over five, 10, or 15 years, you might have 30 years.

However, be sure to compare the interest rates on the old and new loans—including both your original mortgage and the home equity loan—as well as any closing costs involved. In a time of rising interest rates, you could end up with more debt and a higher interest rate on all of your debt.

What Are the Closing Costs on a Home Equity Loan?

Many lenders estimate closing costs at 2% to 5% of the loan amount. Some lenders advertise no closing costs, but they may make up the difference with a higher interest rate. One way to compare costs from lender to lender is by checking the annual percentage rate (APR) that each charges. The APR incorporates some, though not necessarily all, of the closing costs into the rate that you’ll actually pay.

Can You Have More Than One Home Equity Loan?

In general, yes, if you have enough equity in the home and satisfy the lender’s other requirements. However, the state where you live may have a say in the matter. For example, Texas prohibits residents from having more than one home equity loan on the same property at the same time.

Can You Refinance a Home Equity Line of Credit?

Yes, as with a home equity loan, you can refinance a home equity line of credit (HELOC).

The Bottom Line

You can refinance an existing home equity loan with a new one, and it may be advantageous if you can get a substantially lower interest rate. But check whether your current loan has a prepayment penalty, which could negate any benefit you would get by switching.

Reviewed by JeFreda R. Brown
Fact checked by Vikki Velasquez

The financial services industry comprises a variety of companies involved in lending, managing, and investing money. It includes banks and credit unions, credit card companies, brokers, asset managers, insurance companies, and payday lenders. Each of these business types has a separate risk profile, which can affect its profit margins.

Key Takeaways

• The financial services industry includes banks and credit unions, insurance companies, asset managers, and a variety of other businesses involved in lending and investing money.
• There are different types of financial services businesses, with margins ranging from 5% to over 24%.
• The average profit margin for financial services businesses is around 10% as of 2024.

Understanding the Financial Services Industry

The financial services industry has served as common ground for investors seeking steady growth and income for decades, despite the 2008 economic downturn spurred by its mismanagement. Organizations that facilitate banking and insurance services, asset management services, lending and credit services, and brokerage operations have continued to increase their contribution to gross domestic product (GDP) each year, and they have a lasting impact on total stock market performance.

The financial services industry includes a large group of businesses that manage money. This includes banks, credit unions, investment groups, credit card companies, insurance companies, financial technology companies, financial advisors, and even mobile financial services. Profit margin for all these various subsectors of the financial services industry varies; whereas many financial services companies generate a revenue by charging a fee for their services, some more personalized services rake in a higher profit margin.

10.53%

The average profit margin for the financial services industry as of year-end 2024.

Financial Services Industry Profit Margin

Companies in the financial services industry have a strong history of consistency in return as well as steady dividend payments to investors, but not all companies within the sector are created equal. This can be seen in the wide range of profit margins from subsectors and specific companies. For example, although the average profit margin for the financial services industry may be 10.53% (as of Dec. 2024), the profit margin for the industry’s more concentrated subsectors ranges from 5.6% to 24.6%.

To determine whether an investment in the financial services industry is suitable in terms of the tradeoff between risk and return, analyze the sector’s management of cost by reviewing its profit margin. A company’s profit margin is calculated by dividing a company’s net income by its total revenues and is expressed as a percentage.

Most investors view a higher profit margin as more desirable, while a lower percentage may mean a company is not generating enough revenue to cover its operating costs. Analyzing a company’s profit margin is not the only way an investor can determine profitability, but this metric does provide more insight than a review of net earnings alone.

How Much Do Financial Services Professionals Make?

The financial services industry spans a variety of careers, with different levels of qualifications and compensation. Accountants and auditors can expect an average annual income of around $80,000, with higher incomes for those with the valuable CPA designation. Financial planners and investment advisers can earn an average salary between $120,000 and $150,000 per year or higher.

How Do You Get a Career in Financial Services?

Almost all career pathways in the financial services require a four-year degree, with actuarial sciences and finance being among the more common academic majors. In addition, an MBA or other professional certification may be required for higher-level financial careers. Some jobs, especially those that involve trading securities on behalf of clients, may require special certification from FINRA or other government regulators.

What Are the Biggest Challenges for the Financial Services Sector?

According to a survey of 501 key decision-makers at British financial companies, the biggest challenge facing the sector was economic turbulence. 44% of respondents said that this was among the largest difficulties, with regulatory compliance following at 43%. Cybersecurity, technological disruptions, and talent retention were also major concerns.

The Bottom Line

The financial services sector covers a whole ecosystem of businesses involved in handling money, from lenders and credit card companies to asset managers and retirement funds. Each of these lines of business has its own advantages and risk profile. Although profit margins range widely, the average profit margin is typically higher than other industries.

How LIFO and FIFO accounting methods impact a company’s inventory outlook

Fact checked by Suzanne Kvilhaug
Reviewed by Natalya Yashina

All companies must determine how to record the movement of their inventory. The amount a company pays for raw materials, labor, and overhead costs is continually changing. For this reason, the amount it costs to make or buy a good today might be different than one week ago. 

For many companies, inventory represents a large, if not the largest, portion of their assets. As a result, inventory is a critical component of the balance sheet. Inventory can be valued using a few different accounting methods, including first In, first out (FIFO) and last in, first out (LIFO). Inventory accounting methods are used to track the movement of inventory and record appropriate and relevant costs.

Serious investors must understand how to assess the inventory line item when comparing companies across industries—or companies in their own portfolios.

Key Takeaways

• The last-in, first-out (LIFO) method assumes that the last unit to arrive in inventory is sold first.
• The first-in, first-out (FIFO) method assumes that the oldest unit of inventory is sold first.
• LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock.
• FIFO is the most logical choice since companies typically use their oldest inventory first in the production of their goods.
• Deciding between these two inventory methods has implications for a company’s financial statements as this decision impacts the value of inventory, cost of goods sold, and net profit.

Understanding Different Inventory Accounting Methods

Inventory refers to a company’s goods in three stages of production:

• Raw materials are basic goods used in production to generate finished products.
• Work-in-progress are goods being manufactured but not yet complete.
• Finished inventory is goods ready for sale that can be bought and delivered to consumers.

You can take the goods that the company has at the beginning of any given period, add the materials that it purchased to make more goods, subtract the goods that the company sold—also called cost of goods sold (COGS)—and the result is the company’s ending inventory.

Inventory accounting assigns values to the goods in each production stage and classifies them as company assets because inventory can be sold—thus turning it into cash in the future. Assets need to be accurately valued so that the company as a whole can be accurately valued. The formula for calculating inventory is:

$begin{aligned} &text{BI} + text{ Net Purchases } – text{COGS} = text{EI}\ &textbf{where:}\ &text{BI = Beginning inventory}\ &text{EI = Ending Inventory}\ end{aligned}$​BI+ Net Purchases −COGS=EIwhere:BI = Beginning inventoryEI = Ending Inventory​

There are different inventory accounting methods, including first in, first out (FIFO) and last in, first out (LIFO). Companies often try to match the physical movement of inventory to the inventory method they use. The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements: balance sheet, income statement, and statement of cash flows.

First In, First Out (FIFO)

The first in, first out (FIFO) method assumes that the first unit making its way into inventory–the oldest inventory–is sold first. For example, let’s say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each and produces 200 more on Tuesday at $1.25 each. According to the rules of FIFO, if the bakery sells 200 loaves on Wednesday, the COGS (on the income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory on the balance sheet.

Last-In, First-Out (LIFO)

The last-in, first-out (LIFO) method assumes that the last unit making its way into inventory–the newest inventory–is sold first. Therefore, the older inventory is left over at the end of the accounting period. Now, suppose the scenario is the same for this bakery—it produces 200 loaves of bread on Monday at a cost of $1 each and produces 200 more on Tuesday at $1.25 each. If the bakery sells 200 loaves on Wednesday, the COGS—on the income statement—is $1.25 per loaf. The $1 loaves would be allocated to ending inventory on the balance sheet.

LIFO vs. FIFO: Inventory Valuation

LIFO

Since LIFO uses the most recently acquired inventory to value COGS, the leftover inventory might be extremely old or obsolete. As a result, LIFO doesn’t provide an accurate or up-to-date value of inventory because the valuation is much lower than inventory items at today’s prices. Also, LIFO is not realistic for many companies because they would not leave their older inventory sitting idle in stock while using the most recently acquired inventory.

For example, a company that sells seafood products would not realistically use their newly-acquired inventory first in selling and shipping their products. In other words, the seafood company would never leave their oldest inventory sitting idle since the food could spoil and lead to losses.

LIFO isn’t practical for many companies that sell perishable goods and doesn’t accurately reflect the logical production process of using the oldest inventory first.

FIFO

FIFO can be a better indicator of the value for ending inventory because the older items have been used up while the most recently acquired items reflect current market prices. For most companies, FIFO is the most logical choice since they typically use their oldest inventory first in the production of their goods, which means the valuation of COGS reflects their production schedule.

For example, the seafood company—from the earlier example—would use their oldest inventory first (or first in) when selling and shipping their products. Because the seafood company would never leave older inventory in stock (because it could spoil), FIFO accurately reflects the company’s process of using the oldest inventory first in selling their goods.

LIFO vs. FIFO: Impact of Inflation

If inflation were nonexistent, then all inventory valuation methods would produce the same results. Inflation is a measure of the rate of price increases in an economy. When prices are stable, the bakery from our earlier example would be able to produce all of its bread loaves at $1, and LIFO and FIFO would both give us a cost of $1 per loaf. However, in the real world, prices tend to rise over the long term, which means that the choice of accounting method can affect the inventory valuation and profitability for the period.

Assuming that prices are rising, inflation would impact LIFO and FIFO as follows:

LIFO

When sales are recorded using the LIFO method, the most recent items of inventory are used to value COGS and are sold first. In other words, the older inventory, which was cheaper, would be sold later. In an inflationary environment, the current COGS would be higher under LIFO because the new inventory would be more expensive. As a result, the company would record lower profits or net income for the period. However, the reduced profit or earnings means the company would benefit from a lower tax liability.

FIFO

When sales are recorded using the FIFO method, the oldest inventory—that was acquired first—is used up first. FIFO leaves the newer, more expensive inventory in a rising-price environment, on the balance sheet. As a result, FIFO can increase net income because inventory that might be several years old—which was acquired for a lower cost—is used to value COGS. However, the higher net income means the company would have a higher tax liability.

LIFO vs. FIFO: Financial Reporting

LIFO

Companies outside of the United States that must adhere to International Financial Reporting Standards (IFRS) are not permitted to use the LIFO method. Public companies in the U.S. are required to adhere to the generally accepted accounting principles (GAAP)—accounting standards set forth by the Financial Accounting Standards Board (FASB). GAAP permits the use of LIFO and FIFO.

Though the LIFO inventory method does require a robust inventory management system to track different inventory transactions, LIFO systems often require less demand on historical data because the most recent purchases are sold first. For this reason, companies must be especially mindful of the bookkeeping under the LIFO method; once early inventory is booked, it may remain on the books untouched for long periods of time.

FIFO

In addition to being allowable by both IFRS and GAAP users, the FIFO inventory method may require greater consideration when selecting an inventory method. Companies that undergo long periods of inactivity or accumulation of inventory will find themselves needing to pull historical records to determine the cost of goods sold. Though many accounting systems can automate this process, the bookkeeping requirements under the FIFO method result in transactions that continually turn over and do not remain on the books for as long (compared to the LIFO method).

Warning

While U.S. generally accepted accounting principles allow both the LIFO and FIFO inventory method, the LIFO method is not permitted in countries that use the International Financial Reporting Standards (IFRS).

LIFO vs. FIFO: Taxes

LIFO

During a period of rising prices, the most expensive items are sold with the LIFO method. This means the value of inventory is minimized, and the value of COGS is increased. Under the LIFO method, expenses are highest. So taxable net income is lower under the LIFO method, as is the resulting tax liability.

FIFO

In contrast, taxes are usually higher using the FIFO method. Assuming that prices are rising, this means that inventory levels are going to be highest because the most recent goods (often the most expensive) are being kept in inventory. This also means that the earliest goods (often the least expensive) are reported under the COGS. Because the expenses are usually lower under the FIFO method, net income is higher—resulting in a potentially higher tax liability.

LIFO and FIFO: Advantages and Disadvantages

When a company selects its inventory method, there are downstream repercussions that impact its net income, balance sheet, and its requirements for tracking inventory. The pros and cons listed below assume the company is operating in an inflationary period of rising prices.

LIFO

Assuming that prices tend to rise over an accounting period, the LIFO method results in a lower value for the cost of goods sold (COGS), resulting in a lower tax liability at the end of the accounting period. It may also be easier to implement if recently-purchased inventory is more accessible.

However, the LIFO method may not represent the actual movement of inventory. Many companies try to move older inventory first. Depending on the actual shelf life, this may not reflect the real value of the company’s inventory.

FIFO

While LIFO produces a lower tax liability, the FIFO method tends to report a higher net income, which can make the company more attractive to shareholders. It also reports a higher value for current inventory, which can strengthen the company’s balance sheet.

However, if inventory has been stagnant for some time, this method may not reflect the actual cost of materials, especially in an inflationary environment.

LIFO

• Results in lower tax liability compared to other methods

• May be easiest to implement if inventory is easily accessible because it has been recently purchased

• Often does not represent the actual movement of inventory (i.e., many companies try to move older inventory)

• Results in lower net income compared to other methods

FIFO

• Results in higher net income compared to other methods

• Often results in higher inventory balances compared to other methods, strengthening a company’s balance sheet

• Results in a higher tax liability compared to other methods.

• May not accurately communicate the true cost of materials if inventory has been stagnant while prices are rising.

Example of LIFO vs. FIFO

In the tables below, we use the inventory of a fictitious beverage producer, ABC Bottling Company, to see how the valuation methods can affect the outcome of a company’s financial analysis.

The company made inventory purchases every month during Q1, resulting in a total of 3,000 units. However, the company already had 1,000 units of older inventory; these units were purchased at $8 each for an $8,000 valuation. So, the beginning inventory was 4,000 units for Q1.

The company sold 3,000 units in Q1, which left an ending inventory balance of 1,000 units or (4,000 units – 3,000 units sold = 1,000 units).

COGS Valuation

• LIFO: COGS was $37,000 because the 3,000 units that were purchased most recently were used in the calculation of the January, February, and March purchases ($10,000 + $12,000 + $15,000).
• FIFO: COGS was $30,000 because FIFO uses the oldest inventory first and then the January and February inventory purchases. In other words, the 3,000 units were comprised of (1,000 units for $8,000) + (1,000 units for $10,000 or January) + (1,000 units for $12,000 or February)

Below are the Ending Inventory Valuations:

• LIFO Ending Inventory: 1,000 units x $8 = $8,000. The last units (the newest ones) are sold first; therefore, we leave the oldest units for ending inventory.
• FIFO Ending Inventory: 1,000 units x $15 each = $15,000. The first units (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.

LIFO or FIFO: Which One Is Best?

The difference between $8,000, $15,000, and $11,250 is considerable. In a complete fundamental analysis of ABC Company, we could use these inventory figures to calculate other metrics: for example, factors that expose a company’s current financial health and enable us to make projections about its future. The inventory figure a company starts with when valuing its inventory matters. And, companies are required by law to state which accounting method they use in their published financials.

Although the ABC Company example above is fairly straightforward, the subject of inventory—and whether to use LIFO or FIFO—can be complex. Knowing how to manage inventory is critical for all companies, no matter their size. It is also a major success factor for any business that holds inventory because it helps a company control and forecast its earnings. For investors, inventory is an important item to analyze because it can provide insight into what’s happening with a company’s core business.

LIFO

• The newest inventory item is the first item to be sold.

• Net income is often lower.

• Cost of goods sold is often higher.

• Ending inventory on the balance sheet is often lower.

• LIFO often does not represent the actual movement of inventory (because companies try to sell the items at the most risk of obsolescence).

FIFO

• The oldest inventory item is the first to be sold.

• Net income is often higher.

• Cost of goods sold is often lower.

• Ending inventory on the balance sheet is often higher.

• FIFO more closely represents the actual movement of inventory (because companies try to sell the items at the most risk of obsolescence).

Is FIFO a Better Inventory Method Than LIFO?

FIFO has advantages and disadvantages compared to other inventory methods. FIFO often results in higher net income and higher inventory balances on the balance sheet. However, this also results in higher tax liabilities and potentially higher future write-offs—in the event that that inventory becomes obsolete. In general, for companies trying to better match their sales with the actual movement of product, FIFO might be a better way to depict the movement of inventory.

Does IFRS Permit LIFO?

No, the LIFO inventory method is not permitted under international financial reporting standards (IFRS). Both the LIFO and FIFO methods are permitted under generally accepted accounting principles (GAAP).

What Types of Companies Often Use LIFO?

Companies often use LIFO when attempting to reduce their tax liability. LIFO usually doesn’t match the physical movement of inventory because companies are more likely to try to move older inventory first. However, car dealerships or oil companies may try to sell items marked with the highest cost to reduce their taxable income.

What Types of Companies Often Use FIFO?

Companies with perishable goods—or items heavily subject to obsolescence—are more likely to use FIFO. For example, consider a grocery store selling produce: that grocery store is more likely to sell older bananas as opposed to the most recently delivered inventory. If the store sells the most recent inventory it receives, the oldest inventory items will likely go bad.

In addition, consider a technology manufacturing company that shelves units that may not operate as efficiently with age. For example, a chip manufacturer may want to ensure older units of a specific model are moved out of inventory; more recently manufactured units of the same model may be able to better withhold storage conditions.

The Bottom Line

Companies can choose between different accounting inventory methods, including LIFO and FIFO. Companies that opt for the LIFO method sell their most recent inventory first, which usually costs more to obtain or manufacture. The FIFO method results in a lower COGS and higher inventory. A company’s taxable income, net income, and balance sheet are all impacted by its choice of inventory method.