- Even if you weren’t a math major, you need basic computational skills and an understanding of compound interest, inflation, amortization and taxes to be a financially responsible adult.
- As discussed in a previous post, the Rule of 72 is a powerful shorthand way of calculating how many years it will take an investment (or debt) to double.
- Don’t forget to factor in the drag of taxes and inflation on every important money decision you make.
Remember back before the 2008 financial crisis, when people were buying homes with 60 percent of their disposable income tied up in adjustable rate mortgages? It was extremely risky, and many folks ended up losing their homes during the crisis because of one basic thing—they didn’t understand the math. They didn’t understand how their adjustable rate mortgages really worked (e.g., that when rates adjust upward, you have to pay more), and many are still suffering financially.
Today I want to talk about five key financial concepts that you need to understand in order to make smart decisions about your money:
- Computational skills
- Compound interest
1. Computational skills relate to whole numbers, decimals, percentages, fractions and estimation. You can’t escape these basics in real life. For instance, suppose your meal costs $12.41 and you want to leave a tip. Take the decimal in $12.00 and move it one space to the left; that’s $1.20. Well, that’s 10 percent. If you double $1.20 (pretty easy to do in your head), that’s $2.40, and you get 20 percent. If you want to choose a figure in between, then $2.00 would be an appropriate tip. Better than the standard 15 percent but not an overly generous 20 percent.
2. Compound interest. This is the concept of a number building on itself over time. Let’s take a real-life example. Suppose you’re 30 years old, and for the past two years you have put some money into a Roth IRA, so you now have $10,000 in the account. As I mentioned in a previous post, the Rule of 72 is a shorthand way of calculating how many years it will take an investment (or debt) to double in value at a fixed interest rate. If an investment (or debt) has an 8 percent interest rate, then it would double every nine years (72÷8 = 9). In other words, your money or debt would double four times over the course of 36 years, so your $10,000 would grow to $160,000 by age 66. Now let’s take that same $10,000, but say you earn 6 percent a year rather than 8 percent because you chose a more conservative Roth with less risk and not as much exposure to stocks. Two percentage points doesn’t seem like a big difference, but consider this: six goes into 72 12 times. So your money’s going to double every 12 years rather than every nine years—in effect, it’s doubling three times (not four) by the time you reach age 66. So by age 66 you have $80,000—not bad, but only half of what you would have had under the 8 percent compound interest rate scenario above.
3. Inflation—the general increase in prices and the fall in the purchasing value of money—runs at a historical rate of 3 percent annually. This means you have to earn more than 3 percent on your money in the long term just to stay ahead of inflation.
4. Amortization. This refers to the fixed level of payments you make on a loan over time, whether it’s for a home, a car or your education. Let’s use the example of a home. Today a 4.5 percent mortgage is fairly common for a 30-year fixed loan. Let’s say you’re looking at a $250,000 home. If you put down the standard 20 percent ($50,000) and finance the remaining 80 percent ($200,000) at 4.5 percent over 30 years, you’re paying $955 a month. It sounds reasonable, but that’s $344,000, of which $144,000 is interest alone! But there are some math tricks you can use in your favor. Suppose you pay just $100 extra every month. That raises your monthly payment to $1,055 from $955, and that extra $100 you contribute every month will enable you to pay off the loan five years earlier. That saves you $27,000 over the life of the loan!
5. Taxes. In our country, we have a graduated tax schedule that rises with your income level—from zero percent up to 40 percent. You need to factor in taxes for all your important investment, saving and borrowing decisions. Remember the earlier example in which we compared a 6 percent investment to an 8 percent investment? If you were making 6 percent on a tax-deferred basis, you’d still end up with $80,000 at age 66. But if you’re in the 25 percent tax bracket, your account has really only grown to $49,000 in after-tax dollars (at 4.5 percent annually) rather than $80,000 by age 66.
Money decisions are complex, but many of them are based on basic math principles. If you can do the math, that’s great, but you should still seek the experienced counsel of professionals who understand the rules and regulations as well as your options at each stage of life. As a young person, the earlier you seek counsel, the bigger the payoff down the road.
Until next time, enjoy. Gary