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

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2 Time : A Financial Management Tool A penny saved is a penny earned Time is money Im on the clock Im buying myself some time Timing is everything Albert Einstein: quote about compound interest Too many young people dont appreciate the awesome power of the time value of money!!!

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3 Time Reduces Investment Volatility Source: Ibbotson Associates

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4 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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5 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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6 Lets 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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7 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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8 Which Type of Annuity is Better If Youre an Investor?

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9 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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10 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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11 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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12 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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13 What can your grandparents do to prevent inflation from eroding their purchasing power?

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14 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. Lets assume thats in 4 years. What is the value of his gift today if his money is earning 5%? 7% 10%

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15 Problem #4 Kevin is 19 and wants to have $10,000 saved by the time hes 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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16 How could Kevin reach (or exceed) his goal?

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17 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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18 $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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19 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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20 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 dont touch it until age 55?

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21 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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22 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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23 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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24 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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25 The Millionaire Game: A Perfect Metaphor For Compound Interest

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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

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27 YOU WIN $1 MILLION DOLLARS!

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