Financial Management for life

I am sorry that this entry does not display the equations properly. I am trying to figure out why it doesn't work here but is does in MSWord. It will be corrected when I figure it out.


January 8, 2009

To: All my sons and daughters (Blood related and my sons and daughters of the mission)

From: Your Dad

Re: Simple principles and equations of financial management

I want to show you how to buy a house, save for your kid’s education, and save for your retirement. You will find that your life is divided into those three main financial events. These formulas are to take the mystery out of accomplishing those three goals and to give you the power over those “financial managers” who claim to want to assist you but whose goal is to line their own pockets. These formulas will give you to tools to keep from being scammed.

Buying a house

The first thing you need to know if you can afford a house is to know what is your monthly payment. The payment should not be greater than 1/3 of your monthly income. The formula for calculating the payment is as follows.

Payment = ____C_*_i_____
1 - (1 + i) ^ (-n)

C = Cost of the house
i = interest you are being charged per month
n = number of payments
^ means to raise the portion in the left parenthesis by the power in the right parenthesis
* means to multiply

The interest used in the formula is the interest rate being quoted, say 6%, divided by 12 months in a year. So in the formula i that is to be used is i = 0.06/12 = 0.005.
For example, let’s say you are buying a house for $170,000 and the interest is 6% for 30 years. You make at least a 10% down payment, let’s say $20,000 to make this example easy. Then the payment will be:

Payment = _____150,000 * (0.005)____
1 – (1 + 0.005)^(-360)

The first thing that will mess people up is the calculation in the denominator.

(1 + 0.005)^(-360) = 0.16604

If this is not understandable then go back to high school, say to the 9th grade.





Then calculate

__0.005_____ = 0.00599
1 – 0.16604

This is the multiplication factor that you can apply to any price of house to find your payment for a 30 year 6% fixed mortgage.

So your payment will be

Payment = 0.00599 * 150,000 = $899.71 per month.

Your actual payment will be a bit higher to account for payments into an “escrow” account that will pay for your taxes and insurance. The bank doesn’t trust you to pay for those on your own, so they raise your monthly payment to make sure that gets done. They will also want you to buy some life insurance to cover the value of the house in case you die. Don’t buy their insurance. It is way over priced. Go to an insurance broker, I like Northwestern, and buy a term policy that will cover the outstanding principal on the house as it is being paid off. It should cost about $1 per thousand per year. So your life insurance should cost you about $150 per year for this house. You will assign as the beneficiary the bank. They will be satisfied with that. At closing there will be “points” and initiation fees and other fees that are not understandable. That is the bank’s way of gouging you and increasing their profit as if they are not making enough already. Have them explain each one of them. Shop other banks if necessary to lower those costs. Note the actual cost of your house will be,

$899.71 * 360 = $323,895

So the bank is going to make $173,895 on that loan, more than the value of the house.
Be armed with all of this as you go to the bank. They may quote you a monthly payment that is more than it should be to make more money on the deal. They will just skim off the extra in the payment for themselves. This activity is especially true of car dealers. By the way, this formula also works for calculating monthly payment on a car. Assume the car dealer is a shyster.

Saving for College for little Johnny

Should you plan on paying for his education? By the time Johnny gets to college your earning capacity should be many times what an 18 year old could possibly do. If he/she is to get out of school in a reasonable time, 4 to 5 years, they need to be taking 15 to 18 hours per semester. Proper study time should be 3 hours of study per 1 hour of class. Therefore for a 15 hour load they should be studying or in class 60 hours per week. That doesn’t leave much time for work. I say parents should take the responsibility to pay for it with assistance from summer employment from Johnny When he/she is finished they pay it forward. That is they do the same for their kids.
So how much is it going to cost? Tuition, room, and board will be about $12,000 per year at BYU or a state school. That is an absolute minimum. So for a 4 year stint that is $48,000. For you, there needs to inflation figured into the calculation. The tools will be given here to do that. This next formula applies to saving for college or for retirement. What should the installments per month be to provide $48,000 in 18 years? This is called a sinking fund. To calculate the monthly installments use the following formula.

Installments = ____i_____ ___ * T
( 1 + i ) ^ n - 1

T = tuition or retirement
i = monthly interest earned and is compounded
n = number of months

Let us assume that you find a savings plan at a bank that will pay 4% per year. Then your savings plan will look like this.

n = 18 years * 12 months/year = 216 payments
i = 0.04/12 = 0.00333 percent interest per payment

Installment = _________0.00333_______ * $48,000
( 1 + 0.00333)^(216) - 1
So,

(1 + 0.00333)^(216) = 2.050

__0.00333__ = 0.0031699
2.05 – 1

Installment = 0.0031699 * 48,000 = $152 per month.

Note that the total payment is 152 * 216 = $32,832. That’s right. You will pay only $32,832 for a $48,000 education if you start early and use the power of compound interest.

Retirement

Building a retirement uses the same principle of using compound interest to your advantage. So you want to be a millionaire? You will need to be at least a millionaire if you want to retire. Using the same formula as the building of the school fund you can accumulate plenty for your retirement. In this example let us assume that you invest through a tax deferred 401K or IRA plan. Tax deferred is a very important consideration. Accumulate your nest egg without giving away your hard earned cash while you are in a high tax bracket. Then when you retire you pay taxes on what you take out which will be at a lower tax bracket. Within your 401K you invest in safe and secure bonds or other investments that pay a guaranteed 6.5% interest for 40 years. If you start at 25 you have 40 years until you are 65 and you want to have $1,000,000. Turning 65 when you are 25 seems like a ridiculously long time away. Now that I am sailing up to that shore, the journey doesn’t seem like it took that long. Now for the investment part using the previous formula,

n = 40 * 12 = 480
i = 0.065/12 = 0.00542

Monthly investment = ______0.00542_________ * 1,000,000
(1 + 0.00542) ^ (480) - 1

Monthly investment = 0.0004379 * 1,000,000 = $437.90

Now look at how much you have invested really.

Total investment = $437.90 * 480 = $210,192

So you put in $210,192 in and get $1,000,000 out. That is the power if compound interest and time. Now comes the real magic. Assume that you will live to be 95 or 30 years of retirement. Then use the same 6.5% on $1,000,000 in an annuity to pay out monthly in 30 years then how much do you get each month?

Monthly withdrawal = ___i * (1 + i) ^ n__ * A
(1 + i) ^ n -1

For our example,

A = annuity investment = $1,000,000
i = 0.065/12 = 0.00542
n = number of months = 30 * 12 = 360

Monthly withdrawal = __0.00542 * (1 + 0.00542)_^_360__ * 1,000,000
(1 + 0.00542) ^ 360 – 1

Monthly withdrawal = 0.006323 * 1,000,000 = $6,323/Month

So you put in $437 per month for 40 years and take out $6,323 per month for 30 years. Put another way you put in $210,192 and get out 6,323 * 360 or $2,276,391. This is all from the power of compounding.
I wish it were just that easy. The problem is earning that much money per month. When you add up the house, education, and saving for retirement you have $1,488 per month and you haven’t even paid taxes, tithing, or bought groceries. Better get a good job.