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# rci.rutgers.edu

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## rci.rutgers.eduPresentation Transcript

• Time is Money: Personal Finance Applications of the Time Value of Money Barbara O’Neill, Ph.D, CFP
• Time : A Financial Management Tool
• “A penny saved is a penny earned”
• “Time is money”
• “I’m on the clock”
• “I’m buying myself some time”
• “Timing is everything”
• Albert Einstein: quote about compound interest
Too many young people don’t appreciate the awesome power of the time value of money!!!
• Time Reduces Investment Volatility Source : Ibbotson Associates
• So What Exactly Is The Time Value of Money? (Review)
• Key message of remainder of class:
• Compound interest can be...
• Your worst enemy (credit card debt)
The choice is up to you!
• Ways to Calculate TV of Money
• Mathematically
• Financial calculator (e.g. TI-BA35)
• (e.g., Microsoft Excel)
• TV of money interest factor tables
• Let’s Review
• Future value of a lump sum
• Example: Value of \$10,000 gift today in 20 years
• 8% i, N =20, FVF =4.6610 (\$46,610)
• Present value of a lump sum
• Example: Value of a \$10,000 gift in 20 years today
• 8%i, N =20, PVF =.2145 (\$2,145)
• More Review: What Is An Annuity?
• Two types of annuities (according to timing of receipt or payment of \$)
• Ordinary Annuity: payment at end of period
• Examples: bank account interest, stock dividends, car note, mortgage
• Annuity Due: payment at start of period
• Which Type of Annuity is Better If You’re an Investor?
• Annuity Due
• The sooner a dollar is received, the sooner the compounding process begins
• FV and PV of an annuity due are always greater than FV and PV of ordinary annuity
• Common Example: Funding an IRA on Jan. 1 versus April 15 of the following year
• Compound interest magnifies the difference in returns over time
• Key Variables in TV of Money Problems
• N- Number of compounding periods
• % i- Interest rate (for compounding FV or discounting PV)
• PV
• FV
• For annuity calculations, periodic payment
• or receipt amount
• Enter 3 known variables; solve for the 4th (unknown) variable
• Problem #1
• Your first “real” job pays \$32,000 a year to start. How much will you need to be earning in 20 years to maintain the same purchasing power if inflation averages
• 3%?
• 4%?
• 5%?
• Problem #2
• Your grandparents (age 60 and 62) are about to retire next month with a monthly income of \$2,000. Assuming an annual inflation rate of 4%, how much will they need in 10 years to equal the purchasing power of \$2,000 today?
• 20 years?
• 30 years?
• What can your grandparents do to prevent inflation from eroding their purchasing power?
• Problem #3
• Your rich uncle has promised to give you \$25,000. The only “catch” is that you must graduate from college and get a “real job” before he gives it to you. Let’s assume that’s in 4 years. What is the value of his gift today if his money is earning
• 5%?
• 7%
• 10%
• Problem #4
• Kevin is 19 and wants to have \$10,000 saved by the time he’s 25. Thanks to a generous gift from his grandparents, he currently has \$6,500 invested in a bond paying 5%. If he makes no further deposits, will he reach his goal?
• How could Kevin reach (or exceed) his goal?
• Problem #5
• Heather starts a Roth IRA at age 22. She plans to contribute \$3,000 at the end of each year year for 45 years until age 67. How much will she have if her IRA investments earn 4% ?
• 7% ?
• 9% ?
• \$3,000 a Year is About \$60 a Week of Savings
• How can Heather “find” \$60 a week to invest in her Roth IRA?
• Problem #6
• Wendy and Sal just got married and want to save \$15,000 for a down payment and closing costs on their first house. They intend to save \$500 per month in CDs averaging a 4% annual return. How long will it take them to reach their goal?
Hints: Use a financial calculator…The answer is less than 5 years!
• Problem #7
• You quit smoking a pack a day of cigarettes and save \$2,550 a year (savings of \$7 per pack per day). You are 20. How much would you have if you invested the money in a stock index fund averaging a 10% return and don’t touch it until age 55?
• Problem #8
• Lucky you…you won the NJ lottery. You have a choice between receiving \$1,000,000 as an annuity of \$50,000 a year over 20 years or taking \$500,000 as a lump sum payment today. Ignoring taxes for the moment and, assuming a discount rate of 6%, which option is the best deal?
• Problem #9
• You want a \$1 million dollars when you retire and will average a 10% return. How much do you need to save per year if you have…
• 40 years to save?
• 30 years to save?
• 20 years to save?
• 10 years to save?
What do these results tell you?
• Problem #10
• Your grandparents, both age 62, have a retirement fund of \$100,000 saved to supplement their pension and Social Security. Assuming an average annual interest rate of 7%, how long will the fund last if they withdraw \$750 per month? What would you advise them to do?
• Two Take-Home Messages: 1. For every decade that you delay saving, the required investment triples (approx.) 2. Compound interest is NOT retroactive!!!
• The Millionaire Game: A Perfect Metaphor For Compound Interest
• A: Answer A C: Answer C B: Answer B D: Answer D 50:50 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 \$1 Million \$500,000 \$250,000 \$125,000 \$64,000 \$32,000 \$16,000 \$8,000 \$4,000 \$2,000 \$1,000 \$500 \$300 \$200 \$100
• YOU WIN \$1 MILLION DOLLARS!