Deeper Dive in The Rule of 72 Part II

In part one the example of a 14 year old who invests $5000 one time of the money earned while babysitting showed the power of compounding over a long period of time. Of course as effective as it to invest one time for a long period of time is the most effective way to make use of this is to do the same process multiple times .

Parcheesi with 72 Spaces

Continue reading

Deeper Dive in The Rule of 72 Part I

Previously I went over briefly the Rule of 72. After going the rule over with a few people in the last couple of weeks it seems the power of the tool is lost until it is applied in a personal finance context. The math behind the rule is simple. The number of 72 is divided by the interest rate of an investment equals the time in years the money will double.

 

Continue reading

Top 10 Cutest Kittens on Youtube

The Top 10 Cutest Kittens on Youtube is a video that last 9 minutes and 23 seconds. Although many people enjoy these videos I think there are other ways to spend 9 minutes ans 23 seconds.  In the same amount of time I’m going to brainstorm, write this blog and suggest 10 things you can do instead of watch cute kitten videos.

The most amazing thing is the number of viewers that watch this. I wonder if all those people who watched the whole video actually thought of anything else they could be doing. (Just over seven million!)

 

Ten Things (that can be done in the same amount of time)

  1. Drink a couple of glasses of water ; the body is made mostly of water and more water is good for you.
  2. Start a retirement plan
  3. Plant some seeds of some plant; more oxygen in the world can’t be bad.
  4. Go for a short walk; it is healthy and it clears your mind
  5. Call someone you haven’t talked to in a while just to say hi.
  6. Do a quick check of your bills (this helps keep you from getting late fees; you can even set up a calendar reminder to do it monthly)
  7. Read a chapter of a book you’ve been wanting to read
  8. Take a power nap – sometimes a quick charge of your batteries keeps you going
  9. Change your light bulbs to LED (see the impact – bottom of the post)
  10. Write a blog post about things you could do in 9 minutes and 23 seconds (or even better create your own list!)

Have a nice day and do something in 9:23….

After The Storm

I was driving to work today and it was after a storm last night. The one thing I noticed was the sky looked beautiful and the vegetation looked greener. This got me thinking that this is a lot like people’s finances.

AfterTheStorm

When a storm hits there are usually signs something is going to happen. The sky gets dark, the leaves of the trees turn up, the wind picks up, etc. Often we see signs in our financial life. It may be a buyout of a company you are working for, a car that is ready to break down, a pending divorce, a child going to college, etc. Noticing the signs helps set up the appropriate action needed.

The morning after a storm may have done some damage but, it is nature’s way to restart and reset. When a financial setback happens this also gives an opportunity to restart and reset our finances. Planning and taking action before a storm hits is key to how good the restart and reset is.

If you have shudders on your house (the ones that work and not for show) and batten down your house before a storm the better off your house will be. Likewise when you see a financial storm brewing make sure you have the financial shudders that work. One example would be to have a paid off older car rather than a newer with payment car. If you lose income or have increased expenses you are more able to take the hit and move forward with less money going out. Also a paid for car can’t be repossessed, so you’ve eliminated that risk.

In the aftermath of a storm there are opportunities that pop up that you may not have had before the storm. A tree that gets knocked down may provide the space in the yard for a garden. If the tree falls on the house; the insurance money may give you the ability to improve your house. A job loss may provide the time to look for a job better than the one lost, one that may have not been found had you been at work.

Storms are going to happen, it is just a fact of life. Be prepared and move forward after the storm with new momentum.

Beating the Amortization Schedule

Buying a house is exciting. Most people get mortgage to purchase a house. For most people buying a house is the most expensive purchase in their lives. Most people don’t understand what amortization is. This begs to ask the question “If the biggest factor of the biggest expense is not understood, how can you reduce that expense?”

If you play a board game you need to know the rules to be able to play and you need to know what is required to win before you can develop a strategy. When purchasing a home via financing wouldn’t it be in the in your best interest to understand the rules and apply it towards your goal.

Basic Amortization

The word amortize just means periodic. So when you talk about a amortized loan you talk about a loan that has equal periodic payments. (A lump sum is spread out into equal payments. The size of the payments is determined by the time of the life of the loan.) At a zero percent interest the principal is just divided by the periodic payments over the length of the loan. The example below is a $100,000.00 loan with yearly payments over six years and over three years. Payment=Principal/Time is the basic formula. Time and payment are the inverse of each other. If you want to pay off the loan earlier you have to make bigger payments. If you want to have smaller payments you have to increase the time.

PeriodicPayments

Amortization and Interest

Most loans incorporate interest as a form of profit for the mortgage lender. (The following is a basic concept of how a payment is determined; the math is a little more complex and beyond the scope of the article.)

In a monthly scheduled payment loan this is determined by the loan principal times the interest rate divided by 12. This is the monthly interest payment. The remainder of the payment is put towards the principal. (an interest only loan would just be the interest and no principal; you are then doing a lease from the mortgage company.)

Interest = Principal X (Interest Rate / 12)

Payment = (Interest + Principal Payment)

Interest is determined by the total principal so the lower the total principal is the lower the interest would be. It is a direct relation as below:

PrincipalInterestRelation

Amortization Schedule

When the payments are amortized to equal periodic payments the first payments are weighed towards the maximum interest payments because the loan is at the maximum principal amount. Most mortgages are 30 year mortgages so with this context lets look at a amortization schedule’s first payment to compared with the last payment. ( $100,000 loan at 5.25% for 30 years )

The payments are equal throughout the loan but the breakdown is different from the first payment to the last.

1stLast

On the first payment the interest is 3.8 times the size of the principal payment. On the last payment the principal is 275 times the interest. So it only makes sense if you are going to pay more towards the principal it is more cost effective to pay earlier than later. (Time really is money here!)

Here is a look at the first year’s breakdown on the amortization schedule.

1st Year

The real cost for the first year is $5,215 for the loan. This is a effective interest rate of 370% . (I don’t know any stock market investment I could realize that kind of return.) What if you were to make one extra principal payment per month?

Extra Principal Payments

1Extra

The ability to pay an extra principal payment per month is easier in the beginning as the payment increases as you go. The total extra principal payments made was $1,450 which saved $5,176 in interest payments.

This tactic had the added benefit of decreasing the loan term by one year. Until the whole loan is payed off there is a risk of foreclosure. The risk of foreclosure has been decreased by one year.

Reducing Risk

The above example is just an example of one extra principal payment per month. This was just an illustration to show the effect on extra payments on the bottom line. This concept can be applied more aggressively. Two or more principal payments per month increases the savings and decreases the time under the thumb of the lender.

The more of the real estate that is owned by you rather than the lender puts your position of power. The bigger piece of the real estate pie you own for the property the less of a risk you have if the value of the real estate decreases.

Suppose there is a downturn in the economy where you live. You lose your job and the value of your house has decreased. If you have paid extra towards the principal of the house you are at less of a risk of being up side down. If there is a job outside your local area and you are up side down you have made a move more difficult or impossible.

Exploiting Amortization

There are other ways to exploit the amortization schedule financial structure.

  • Bi-weekly or weekly payments are a way to accelerate the payment of the principal. This in turn decreases the interest paid.
  • Taking lump sums and applying towards principal.

Tax return

Work bonus

Inheritance

  • Applying small periodic gains. Get a raise, save on cable, get a side job, etc and apply the gain towards the principal and increase the value of that gain.

Short Term Loan Shifting

This is the idea that if you could take a short term loan and pay the mortgage principal down. This works with only with positive cash flow (spending less then you make) The main gain is the realized cost of the short term loan is less than the cost of the amortized interest. There are better people at explaining this than me but, using an equity line of credit is the vehicle to make this happen.

See: TruthinEquity.com  for this method explained.

The bottom line this is a time is money equation. An amortization schedule understanding can help you save both time and money.

 

 

 

 

 

 

The Power Of Choice

Lately it seems to me there is a flood of people who I bump into who don’t realize the relation of their choices to the results of those choices. They ignore the basic concept for every action there is a reaction. You hit one domino and the rest fall as well.

I have a goal to have my money work for me rather than me working for money. The goal is a relatively simple math problem have your money create enough money to cover expenses.

The concept is simple but, getting the goal accomplished takes some preparation, perspiration, and inspiration . The reason I bring up my goal is it reflects back onto the decisions I make today.

One of the most basic financial choices I make everyday is whether or not I purchase something. Based upon that choice I am building up or taking away from momentum to or from my goal.

When I purchase something I always bounce through the following list in my mind:

  1. Is this something I need? or can I do without?
  2. Can the item purchase be delayed for a later time?
  3. Do I have the ability to buy cash (not via credit, incurring debt)

This list helps me keep my direction and focused when making purchases. I challenge the reader to make your own list based upon your own goals. This will help you guide your choices towards what you want to accomplish.

What are the dominoes that can fall if you buy a car without having the cash to buy it?

  • You have to finance the car purchase price which also includes the tax and related fees–>
    • The ability to be up-sold on more expensive features is easier–>
      • The amount of hours you have to work is increased due to the increased cost–>
        • The amount of free time is decreased due to having to work more to pay for the increased price
  • The risk of having a car with payments–>
    • Ability to sell the car is decreased; you don’t own the title
    • If you lose your job the ability to make car payments has decreased–>
      • The chances of a car getting repossessed is increased
  • The opportunity to save future earnings has decreased–>
    • The ability to invest in the future has decreased–>
      • The cash needed to take part in future deals has decreased

This is just an example of one decision and you can see all the ripples that can happen. Everyone has made some decisions they could of made better if they just asked themselves what are the most likely outcomes of these decisions.

When you have the next decision to make ask yourself some things to help you get to the best outcome.

  • Does this help me accomplish my long term goals?
  • What are the risks? (How can I minimize those risks?)

Write down on paper what dominoes could fall if you make your decision one way then the alternative way. Find the path that makes the most sense.

Apply this to some of your financial challenges. See how you move closer to your goals rather then being a part a financial goal that someone else planned.