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rci.rutgers.edu

  1. 1. Time is Money: Personal Finance Applications of the Time Value of Money Barbara O’Neill, Ph.D, CFP
  2. 2. Time : A Financial Management Tool <ul><li>“A penny saved is a penny earned” </li></ul><ul><li>“Time is money” </li></ul><ul><li>“I’m on the clock” </li></ul><ul><li>“I’m buying myself some time” </li></ul><ul><li>“Timing is everything” </li></ul><ul><li>Albert Einstein: quote about compound interest </li></ul>Too many young people don’t appreciate the awesome power of the time value of money!!!
  3. 3. Time Reduces Investment Volatility Source : Ibbotson Associates
  4. 4. So What Exactly Is The Time Value of Money? (Review) <ul><li>Key message of remainder of class: </li></ul><ul><li>Compound interest can be... </li></ul><ul><li>Your worst enemy (credit card debt) </li></ul><ul><li>Your best friend (5+ decades of compound interest) </li></ul>The choice is up to you!
  5. 5. Ways to Calculate TV of Money <ul><li>Mathematically </li></ul><ul><li>Financial calculator (e.g. TI-BA35) </li></ul><ul><li>Computer spreadsheets with formulas </li></ul><ul><ul><li>(e.g., Microsoft Excel) </li></ul></ul><ul><li>TV of money interest factor tables </li></ul>
  6. 6. Let’s Review <ul><li>Future value of a lump sum </li></ul><ul><ul><li>Example: Value of $10,000 gift today in 20 years </li></ul></ul><ul><ul><li>8% i, N =20, FVF =4.6610 ($46,610) </li></ul></ul><ul><li>Present value of a lump sum </li></ul><ul><ul><li>Example: Value of a $10,000 gift in 20 years today </li></ul></ul><ul><ul><li>8%i, N =20, PVF =.2145 ($2,145) </li></ul></ul>
  7. 7. More Review: What Is An Annuity? <ul><li>Two types of annuities (according to timing of receipt or payment of $) </li></ul><ul><li>Ordinary Annuity: payment at end of period </li></ul><ul><ul><li>Examples: bank account interest, stock dividends, car note, mortgage </li></ul></ul><ul><li>Annuity Due: payment at start of period </li></ul><ul><ul><li>Examples: insurance premiums, leases </li></ul></ul>
  8. 8. Which Type of Annuity is Better If You’re an Investor?
  9. 9. Annuity Due <ul><li>The sooner a dollar is received, the sooner the compounding process begins </li></ul><ul><li>FV and PV of an annuity due are always greater than FV and PV of ordinary annuity </li></ul><ul><ul><li>Common Example: Funding an IRA on Jan. 1 versus April 15 of the following year </li></ul></ul><ul><li>Compound interest magnifies the difference in returns over time </li></ul>
  10. 10. Key Variables in TV of Money Problems <ul><li>N- Number of compounding periods </li></ul><ul><li>% i- Interest rate (for compounding FV or discounting PV) </li></ul><ul><li>PV </li></ul><ul><li>FV </li></ul><ul><li>For annuity calculations, periodic payment </li></ul><ul><li>or receipt amount </li></ul><ul><ul><li>Enter 3 known variables; solve for the 4th (unknown) variable </li></ul></ul>
  11. 11. Problem #1 <ul><li>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 </li></ul><ul><li>3%? </li></ul><ul><li>4%? </li></ul><ul><li>5%? </li></ul>
  12. 12. Problem #2 <ul><li>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? </li></ul><ul><li>20 years? </li></ul><ul><li>30 years? </li></ul>
  13. 13. What can your grandparents do to prevent inflation from eroding their purchasing power?
  14. 14. Problem #3 <ul><li>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 </li></ul><ul><li>5%? </li></ul><ul><li>7% </li></ul><ul><li>10% </li></ul>
  15. 15. Problem #4 <ul><li>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? </li></ul>
  16. 16. How could Kevin reach (or exceed) his goal?
  17. 17. Problem #5 <ul><li>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% ? </li></ul><ul><li> 7% ? </li></ul><ul><li> 9% ? </li></ul>
  18. 18. $3,000 a Year is About $60 a Week of Savings <ul><li>How can Heather “find” $60 a week to invest in her Roth IRA? </li></ul>
  19. 19. Problem #6 <ul><li>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? </li></ul>Hints: Use a financial calculator…The answer is less than 5 years!
  20. 20. Problem #7 <ul><li>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? </li></ul>
  21. 21. Problem #8 <ul><li>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? </li></ul>
  22. 22. Problem #9 <ul><li>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… </li></ul><ul><li>40 years to save? </li></ul><ul><li>30 years to save? </li></ul><ul><li>20 years to save? </li></ul><ul><li>10 years to save? </li></ul>What do these results tell you?
  23. 23. Problem #10 <ul><li>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? </li></ul>
  24. 24. Two Take-Home Messages: 1. For every decade that you delay saving, the required investment triples (approx.) 2. Compound interest is NOT retroactive!!!
  25. 25. The Millionaire Game: A Perfect Metaphor For Compound Interest
  26. 26. 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
  27. 27. YOU WIN $1 MILLION DOLLARS!

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