When comparing investments, it is always a good idea to compare their risks and returns. Naturally, if one investment is much riskier than another, it must pay an appropriately higher rate of return to warrant your attention. Judging the relative riskiness of investments can be extremely difficult, and comparing returns is not as easy at it might appear. This blog post talks about one aspect of comparing returns from tax lien investments with other investments.
Arizona tax lien certificates pay simple interest. The actual computation for interest earned on an Arizona CP is covered in a separate blog post entitled “Calculating Interest Earned on Arizona Tax Lien Certificates”. What simple interest means is that your interest does not earn interest. Arizona CPs accrue simple interest on the initial investment amount until the CP is redeemed or the investor successfully forecloses on the property. For example, assume you buy a $1,000 CP at a bid rate of 8%. After one year, you will have earned $80 in interest, but it won’t be paid out to you, as you have to wait for redemption for that to happen. The next year, you again earn $80, because the interest is calculated only on your principal and not on any interest accumulated along the way. After three years, you would have earned a total of $240 in interest, bringing your redemption amount to $1000 + $240 = $1,240.
Compound interest is where your interest earns interest also. The more frequently the compounding occurs, the better off you are. Picking up again on the example above, let’s assume that compounding occurs yearly. After year 1, the results would be the same: you earn $80 and have a total principal plus interest of $1,080. In year 2, however, you earn interest on $1,080, rather than $1,000, as would be the case with simple interest. So, during year 2 you would earn $1,080 * 8% = $86.40 in interest and have a total value at the end of the year of $1,166.40. During year 3, you would earn $1,166.40 * 8% = $93.31 and have $1,259.71 at the end. So, with annual compounding, you would have earned $19.71 more than you would have with simple interest.
This matters when comparing tax lien investments with other investments that offer compound interest, either directly, or indirectly by paying out interest along the way that can be reinvested. Most corporate bond yields reflect semiannual compounding, for example. The more frequent the compounding, the higher the interest rate, and the longer the time period, the greater the benefit of compounding becomes. The following chart compares the growth of a $1000 investment over five years at 4% and at 16% with no compounding (simple interest), annual compounding and monthly compounding.
Simple Interest versus Compound Interest
You can see that at the end of year five, at 16%, monthly compounding leaves you with $414 more than simple interest!
When considering purchasing an Arizona tax lien in the secondary market, one should always bear in mind that the interest you will earn will be based on the principal amount of the lien only, and not an any accrued interest that you might have to pay to the selling investor. The older the lien is, the more this will matter. Consider a $1000 tax lien certificate that, for simplicity’s sake, has a rate of 10%, is five years old and has never been subtaxed. It would have accumulated interest of $1000 * 10% = $100 per year or $500 in total. If you were to buy this from a seller at its fully accreted value of $1500, your return going forward would be interest of $1000 * 10% and not $1500 * 10%. This would essentially lower your return to $100 / $1500 = 6.7%.
When you see secondary market offerings, such as those on our Listings page, you should consider this example when deciding to bid for certificates where the seller expects to be paid for the accrued interest. They might understand your point and negotiate with you. On the other hand, you don’t have to wait as long, if at all, to foreclose on older certificates, leading many sellers to expect to be paid in full, despite the disadvantage of simple interest demonstrated herein.