Choosing a fund? Check fees, too

You probably realize that mutual funds charge fees. But if you’re like most people, you don’t really understand what the fees are for, and what’s reasonable and not reasonable. So let’s run through some fees, shall we? After all, while you can’t know how much a fund will earn for you in a given year, you can tell how much it will be charging you.

• Loads. These are simply sales charges – commissions paid to the brokers who sell funds. Some funds have them and others don’t. Many load fees are as high as 5.75 percent and sometimes more. Imagine a fund with a front-end load of 5 percent. If you deposit $10,000, you’ll immediately lose $500. Ouch.

• Expense ratio. This number reflects what percentage of a fund’s assets are deducted from it each year, typically to cover normal operating expenses. The median expense ratio for all funds is roughly 1 percent, but some funds charge as much as 3 percent or more. The following two fees are included in the expense ratio.

• 12b-1 fee. This is mostly a marketing fee, covering the fund’s advertising and more. Ironically, fund shareholders are bearing the cost of attracting additional money to the fund – even though when funds grow too large, their performance can suffer. A 12b-1 fee is often 0.25 percent, but it can be higher.

• Management fee. This fee compensates the fund’s management – regardless of performance. And oddly enough, while you might expect the percentage of this fee to drop as a fund grows in size, that doesn’t always happen.

These fees all add up, making it hard for a fund to outperform the market average. That’s why many investors rightfully prefer index funds. Vanguard’s S&P 500 index fund, for example, sports a tiny expense ratio of just 0.18 percent. Still, there are some top-notch funds out there with relatively low fees and market-beating track records.

If you’re looking for some outstanding mutual funds, try our Motley Fool Champion Funds newsletter service for free at www.fool.com/shop/newsletters.

Ask the Fool

Q: Is it smart to pay “points” on a mortgage? — R.L., Aspen, Colo.

A: It depends on how long you expect to be in the house. First off, understand that a point is 1 percent of the mortgage loan. On a $200,000 loan, one point would be $2,000. There are “origination” and “discount” points.

Origination points are sometimes charged for originating, or launching, your mortgage. Paying discount points, which lowers your interest rate (and thus your payments), is optional. The idea is that if you cough up a little extra money at the beginning, you can pay less over time. The more points you pay, the lower the interest rate you get.

The longer you expect to stay, the more worthwhile it can be to pay points. If you pay a few points and then sell your home after two years, you’ll have enjoyed lower monthly payments because of the lower interest rate. But in two years, the savings probably won’t have made up for the points you paid. If you paid $4,000 in points to save $50 per month, it will take you 80 months, about 6 1/2 years, to break even.

Learn more and try out various scenarios with online calculators at www.fool.com/homecenter and www.quickenloans.com.

My smartest investment

I purchased 50 shares of General Dynamics for $2,500. The price rose from around $50 to more than $100 per share. The stock split 2-for-1, and I had 100 shares. Shares doubled in price again, and the stock split again. The last time I checked, my 200 shares were worth more than $20,000. — Paul Taylor, Oro Valley, Ariz.

The Fool Responds: Since you wrote us, the defense contractor’s shares split again, and your 400 shares were recently worth more than $25,000. You know, of course, that the splits aren’t what are making you wealthier. If your shares never split, they’d just be trading about $520 each, and you’d still have more than $25,000. What you did right was to buy into a healthy, growing company — and hang on, for more than a decade so far. Shares dropped from a split-adjusted $50 or so in 2002 to the high $20s in 2003, causing many people to sell out of fear, not logic. Those who hung on were rewarded.