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1 Time is Money: Time is Money: Personal Finance Personal Finance Applications Applications of the Time Value of of the Time Value of Money Money Barbara O’Neill, Ph.D, CFP
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Time is Money: Time is Money: Personal Finance Applications Personal Finance Applications

of the Time Value of Moneyof the Time Value of Money

Barbara O’Neill, Ph.D, CFP

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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!!!

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Time Reduces Investment Volatility

Source: Ibbotson Associates

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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)

• Your best friend (5+ decades of compound interest)

The choice is up to you!

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Ways to Calculate TV of Money

• Mathematically

• Financial calculator (e.g. TI-BA35)

• Computer spreadsheets with formulas

– (e.g., Microsoft Excel)

• TV of money interest factor tables

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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)

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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– Examples: insurance premiums, leases

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Which Type of Annuity is Better If You’re an Investor?

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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

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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

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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%?

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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?

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What can your grandparents do to prevent inflation from eroding

their purchasing power?

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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%

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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?

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How could Kevin reach (or exceed) his goal?

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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% ?

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$3,000 a Year is About $60 a Week of Savings

How can Heather “find” $60 a week to invest in her Roth IRA?

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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!

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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?

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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?

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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?

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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?

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Two Take-Home Messages:

1. For every decade that you delay saving, the required investment triples (approx.)

2. Compound interest is NOT retroactive!!!

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The Millionaire Game:

A Perfect Metaphor For Compound Interest

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A: Answer A

C: Answer C

B: Answer B

D: Answer D

50:50

151413121110987654321

$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

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YOU WIN $1 MILLION DOLLARS!