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Poway Unified School District and the Power of Compound Interest

In the past few days, Fox News and other organizations have reported about bonds that Poway Unified School District, near San Diego, CA, has issued.  The bonds were issued almost a year ago, in September 2011; their issue was approved by the school board almost two years ago (in October 2010).

The reports have centered around the assertion, or at least implication, that tax payers have been totally ripped off by the bond offering.  Here is a link to the Fox News article as it appeared on August 10, 2012:

California School District Will Spend $1 Billion to Borrow $100 Million

These bonds were issued after approval of voters of Proposition C on February 5, 2008.  The proposition that appeared on voters’ ballots read:

PROPOSITION C: “To provide safe and modern school facilities, improve student learning, and qualify for approximately $20 million in State matching money, shall School Facilities Improvement District No. 2007-1 of the Poway Unified School District issue $179 million in bonds at legal interest rates to upgrade aging classrooms, libraries, science & computer labs; replace roofs, plumbing, heating, ventilation and electrical systems; improve fire alarms and school security; remove hazardous materials; fund needed facilities, subject to mandatory audits, independent citizens’ oversight and without an estimated increase in tax rates?”

The proposition passed with 63.9% of the voters approving.

The article makes some strange assertions and presents many facts that are either incorrect or misleading.  This post discusses some of these inaccuracies and then discusses the financial aspects of the bonds.

Inaccurate Information in the Fox News Report

The Fox News report makes the following untrue statements:

  1. “Its being called a loan that not even a subprime lender would make.”  Who calls it that?  If the details of the loan make it such a raw deal for tax payers and such a good deal for banks, then why would a subprime lender not be interested?  Likewise, if the deal is such a bad investment for a lender, wouldn’t it be a good deal for the tax payers?  From either angle, this assertion makes no sense.
  2. “…they can’t be paid off early or refinanced.”  Yes, it’s true that non-callable bonds cannot be paid off early.  But, they can certainly be refinanced at the end of the term.
  3. “And the Poway district has already borrowed millions of dollars at nosebleed 12.6% interest rates.”  When?  In the 1980′s?  Poway’s CPA certified financial statements do not show any evidence of loans at such rates.  See  http://www.powayusd.com/depts/bss/finance/ for CPA certified audit reports of Poway’s budget, debts, etc.  In addition, even the lowest rated municipal bonds do not pay interest this high.  Remember that the market, not the school district, sets the interest rate.  The market sets the interest rate based on the credit worthiness of the school district.  Moody’s rates Poway’s credit as Aa2.  This is an investment grade rating.  In addition, Poway has had a Aa2 or better rating for at least the last 15 years.  Municipal bonds with such high credit ratings have never yielded interest rates at levels even close to 12.6% in the recent past.
  4. The article states that the underwriters of the bond issue will get $1.4 million in fees which, according to the article is a “sweet deal”.   The implication is that the underwriters are ripping off the tax payer.  In truth, these fees are less than 1.5% of the value of the bond offering.  While this amount may sound high, there is much more to underwriting a bond offering than meets the eye.  1.5% is within the range of “reasonable and customary” fees for bond underwriting.  This is not some sort of unusual “sweet deal”.
  5. The article states that school administration and teacher compensation chew up 85% of the school’s budget.  This is not true.  According to the certified financial statements from the school district, the district spent $244,737,036 on teacher compensation and administration in the 2010-2011 school year.   The total school budget was $337,800,038.  So, the real number is 72.45%.

It should be pointed out that the district budget for 2012 is $10 million less than it was for 2009 and that spending per pupil is less than $10000 per student, despite the fact that the San Diego area has a high cost of living.  $10000 per student is within the average range for primary and secondary public education cost in the United States.  Compare this to the many districts in New York that spend more than $20000 per student.

There are other inaccuracies and misrepesentations of facts in the article.  The reader of this blog is encouraged to dig into the financial reports of the district.

The True Financial Implications of Poway Unified School District’s Bond Offering

Interest on the $105 million bonds will accrue, but not be paid, for 20 years.  After 20 years, interest will be paid on the $105 million principle as well as the interest that will have built up over the first 20 years.  These types of bonds are called convertible zero coupon bonds.  The intricate workings of them can be difficult to understand.  However, it is easy to make an excellent approximation.

Over 40 years, Poway Unified School District will pay $981 million to pay off these bonds.  This is equivalent to the interest rate on a common bond or loan of approximately 5.75%.

Looking at this another way:  If you were to deposit $105 million into a bank CD promising to pay you 5.75% interest each year for the next 40 years, you would have just over $981 million in 2052!  This is the power of compound interest.

How does a 5.75% interest rate compare to other municipal bonds?  Well, as stated above, Poway Unified School District has a Aa2 credit rating.  This is not an uncommon credit rating for municipalities in the United States.  A quick check of today’s yields on 40 year municipal bonds with Aa2 credit ratings shows yields are right around 5% today.  Rates last fall for 40 year bonds were approximately 0.75% higher.  As expected, Poway paid the market rate based on its credit rating.

Closing Thoughts

Poway’s Unified School District’s credit worthiness is not any different than hundreds of municipalities around the country.  It is investment grade; meaning that buying its bonds is a fairly low risk investment.  The bonds were issued by the district with the approval of taxpayers.  The interest rate is at the market rate.

The bonds will not result in a tax increase for at least 20 years.  After 20 years, the interest paid will be a small percentage of the district’s budget.  In addition, inflation over the next 20 years significantly decreases the impact of the interest payments that will have to be made.  It is not unreasonable to envision a situation where minor budget cuts would completely offset the interest payments.

Instead of focusing on a fairly low risk scenario that is common to local governments throughout the country, and instead of misreporting a vast majority of the facts about this bond issue, news organizations could better serve the public by reporting on real dangers to future taxpayers.  One example of such a real danger is the chronic under funding of government pension plans, including Poway Unified School District’s teacher retirement plan.  Without significant tax increases in the future, its probable that drastic cuts in government services will be necessary for governments to meet their pension obligations.

Web Filtering – Limited Access Wireless

Imagine a business where employees need secure, full,  access to the internet.  At the same time, imagine that this business needs to provide customers and vendors with access. But, it must keep its proprietary information out of the hands of these visitors. And it needs to limit their access to websites with questionable content.

A similar need might arise in a home environment with children. Perhaps parents need full internet access while children only need access to websites that the parent approves of.

This post is the first of a series of posts that describe a method of accomplishing this.

The network system diagram shown below implements this system on a small-scale, as needed in a small office or home:

Open filtered internet and secured full internet simultaneously

Internet connectivity is provided by an ISP such as AT&T DSL, Time Warner Cable, or through a wireless internet provider such as Clear. Connection to the internet is through a modem.

An Ethernet cable connects the modem to a wireless router. The router shown above is a Linksys WRT54GL Router. The WRT54GL is certainly not the most sophisticated wireless router on the market. But, it is one of the most widely used wireless routers, has been on the market for more than 6 years, and has a track record of solid, reliable, performance. This router is configured to provide unfiltered access to the internet. Any computer or other WiFi device connected to it has full internet access. Communications between this WRT54GL and the devices connected to it are encrypted so that interception is very difficult.

The second Linksys WRT54GL, the one on the right, is connected to the first wireless router through an Ethernet Cable. It is configured so that it can be accessed without an encryption key or password. This means that data transferred through it is not secure and can be easily intercepted. However, data security is usually not desired for public internet hotspots. (If desired, encryption could be added to limit access).

This second wireless router filters the internet so that undesired websites are not accessible.

This basic system can be easily expanded by adding more wireless routers. An expanded system can provide:

  • Enterprise level wireless coverage for medium size businesses
  • Hotspot coverage over a larger area, such as an apartment complex, shopping mall, or outdoor area
  • Simultaneous filtered and non-filtered internet access
  • Multiple levels of filtering for different types of users

I am happy to help your organization with a custom or turn-key wireless system design.  However, subsequent posts will explain in detail how to set up these key components of a multi-privilege level WiFi system.

Should I Pay a Loan Off Early?

Dear Jim,

I have a 5 year loan for a vehicle that I took out 4 1/2 years ago.  I have 6 months  left to pay and the balance is just over $2400.  The interest rate is 7.75%.  I also have $3000 in cash that I am thinking about investing.  Should I invest it or should I pay off my car loan?

A friend told me that I’ve already paid most of the interest on the loan and that, from this point out, it’s not worth paying off since I’m pretty much just paying principle at this point.

Chuck

Chuck, your friend is both right and wrong.

Assuming you haven’t made any extra payments along the way, it looks like you borrowed about $24000 to purchase your auto.  Over the past 54 months (4.5 years), you have paid about $5000 in interest.  But, if you keep the loan and finish making the payments over the next 6 months, you will only have to pay $65 in interest.  Your friend is absolutely correct that you have already paid the majority of interest on this loan.

However, it’s probably best to pay off the loan now.  Here are explanations of your two options:

  1. Pay the loan off now.  You will save $65 in interest.  Over the next 6 months, you can save ~$500 each month instead of making payments.  You’ll have $3000 in cash in 6 months that you can invest.  Even if you don’t get any interest on your savings over the next 6 months, you will have saved $65 in interest.
  2. Keep making payments and invest your $3000 in a safe investment like a CD.  You’ll pay $65 in interest on the loan.  If you look around carefully, you should be able to find a CD that pays 0.5% interest.  Bankrate.com can help you find the best CD rates.  But, at 0.5%, your CD will only provide you with $7.50 of interest income.  Depending on your tax situation, you could pay up to 26% tax (15% Federal plus 11% state if you live in Oregon or Hawaii) on this interest income.  At the end of 6 months, you will have $59. 45 less in your pocket.

It’s clear that the first option is usually better.

One exception may be in the case where you are among the 28% of Americans without emergency savings.  If you have no savings, it may be advisable from a psychological perspective to start building an emergency fund rather than saving the $65 by paying off the auto loan early.  You’ll still have $65 less at the end of 6 months.  But, often, people find it easier to borrow money rather than give up savings.  If you have savings, you’ll carefully think before you dip into it.  With no savings, however, it can be more tempting to label purchases as “emergencies” and charge them to a credit card.

No Longer Funding 401K?

On May 23, 2012, Yahoo Finance posted an article  by K. W. Callahan explaining why he is no longer funding his retirement account.  Here is a snapshot of Mr. Callahan’s article.

NoLongerFundingRetirement

Mr. Callahan has a business degree from the Indiana University Kelley School of Business.  Unfortunately, he seems to have forgotten much of what he learned in business school.  There are many misconceptions about the way the equity markets work.  But, this post concentrates on the power of dollar cost averaging and how Mr. Callahan has missed out on a significant opportunity to grow his retirement savings.

Mr. Callahan explains that he stopped contributing to his 401K in late 2007.  At that time, his retirement account balance was about $38000.  He correctly points out that his balance was only $33000 in late 2011 – almost 5 years later.

Assuming he makes about $50000 per year, a 3% contribution would have amounted to $125 per month.  If he had saved $125 per month in a non-interest bearing account, he would have added $7500 to his savings over the course of 5 years.  That would have brought his retirement savings today up to around $40000.

But, a better strategy would have been to invest his 401K in a diversified basket of securities reflecting the total market value, such as the iShares Russell 3000 Index Fund (IWV), and keep contributing.  If Mr. Callahan had done this, he would have had around $45000 as of June 1, 2012.

The reason is simple.  With regular contributions at set intervals, investors are able take advantage of low points in the market.  For example, purchasing $125 could have bought 3.15 shares of  (IWV) on February 2, 2009 — at the low point of the market.  A similar investment of $125 on April 1, 2011,  would have purchased only 1.56 shares.  Catching the up’s and down’s of the market by purchasing set amounts at regular intervals allows investors to accumulate more shares when prices are low and less shares when prices are high.   This is dollar cost averaging.

Obviously, there were months that such a strategy would have left Mr. Callahan’s account with less than $38000.   But, over a reasonably long period of time (years, or decades),  dollar cost averaging using a diversified basket of securities has historically produced much better yields than buying securities all at once and then holding them.  And it has produced better results than government bonds, real estate, gold, or other investments.

Dollar Cost Averaging
Mr. Callahan's Investment Alternatives

The lesson is to keep investing a set amount regularly in a broad range of investments.  Never give up.