Part 1 Review
This post is the second in a series on Money Math. The purpose of this series is to offer insights and means to measure your money management progress.
In Part 1, I reviewed the aspect of measuring Cost to Benefit, how to determine if your income is satisfying your needs, and how to measure your Cash Flow and Debt to Equity.
I concluded that you would need to use Money Math for your Due Diligence to make progress as your own personal finance manager.
Opportunity Costs
I have a lot of related knowledge, but I feel a reference to other voices of authority will help the message be clear and valuable. So, I will mention a book where I found many of the formula references that are included in this post. You can find this book in your local library, hopefully. The book is Personal Finance 101, by Alfred Mill, which you can read for more details.
Opportunity Costs are related to your spending decisions. I made a short explanation in Part 1 but feel a longer explanation will be important for your spending criteria. That is, this involves your evaluation of spending options.
The concept here is that you will be well-served to create a means of thinking about a purchase before making the buying decision.
This may be as simple as asking yourself, “Do I need that now?” Then, depending on your level of debt, the amount of your savings, and your cash flow, will this purchase interfere with other things I might want to do?
Sometimes you need to ask, will my plans for a fun outing create more debt? That might make the fun memories a little painful later, when you ask, was it worth it?
There are other situations that may affect your ability to save. Those usually can be summarized as a choice between convenience and sacrifice. One such choice is whether to mow your yard or hire someone else to mow it for you, at a cost. Did you have other uses for that money?
If you mow your own yard, you save the money you would have paid someone else. If you put that money into a savings account, you will have funding for another opportunity, perhaps to pay down some debt and save on interest expenses.
In other words, you assign value to your spending options. That requires thinking beyond the moment and the present situation. Some options will stand out as better choices, if you do Money Math!
Rule of 72 for Compounding
The Rule of 72 is to calculate how long an investment will take to double in value. The formula is Rule of 72 = 72/Interest Rate = Number of Years to Double in Value. This is referred to as Compounding of earnings to grow your investment. When the earnings are left in the investment, they will increase the rate of growth, called compounded earnings. This formula just allows you to see how long it takes to double your investment in the process. That is a fun fact!
An example would be a Certificate of Deposit earning 4% at your local bank. The calculation would be 72/4 = 18 years to double your investment.
More importantly, a reasonable return in a mutual fund inside your 401k account may average 8% per year. The calculation would be 72/8 = 9 years to double your original investment! When you are consistently making contributions to your retirement account for 40 years or more, Compounding becomes an exciting part of your retirement investments!
Dollar Cost Averaging
Since I mentioned your retirement account, I should include a review of Dollar Cost Averaging. It is the reason you must be consistent with contributions to your retirement account.
The stock market goes up and it will go down. That is referred to as the Business Cycle. Buying stock drives the prices up and selling drives the prices down. You cannot control those forces. But you can learn to work with it.
Dollar Cost Averaging means you purchase shares with your contributions as prices increase and as prices decrease but the total of purchases will average out and any dividends added in will help to offset losses and aid in the compounding process. The long-term goal is to achieve a reasonable return over time. Have a goal in mind and change investing strategies as needed. Seek out good advisors!
This is Good Money Math to know!
A Rat in the Woodpile
Ever heard of the Consumer Price Index? That is a comparison of the price of commonly used products at the retail level on a given date compared to the same information a month or a year earlier. Most of the time, the data shows an increase. We call that data the percentage of inflation.
Inflation is no one’s friend. But it is a fact of your financial life.
You must keep an eye on inflation news and what it means to your purchasing power. It will make your evaluation of Opportunity Costs even more important.
A quick note to help you calculate the effect, a 3% increase in prices, means you can only buy 97% of what you could with the same dollar in the previous period.
Of course, if you get a 3% raise, then you can buy the same number of items as before. But that also means that you got a raise just to stay even not to be able to buy more!
Hence, we have a “rat in the woodpile”!
Funding Emergencies
Most credit card companies will claim to be the hero by coming to your rescue when you have an emergency expense. The hard question after that is how long will it take to pay that debt off?
An interesting side note is that most people under 30 years old have grown up with many credit card commercials on TV. However, credit cards have grown with the internet. Before that, your main source of getting a loan was with a bank or loan shark.
If you believe that credit cards are a great addition to our society, you should read Credit Card Nation, by Robert D. Manning. He notes that a lot of political favors were given to allow higher interest rates to be charged in many states, where credit card companies would locate offices and processing centers.
The internet has made card reader technology possible. The availability of easy credit at higher interest rates has allowed many people to build credit balances much faster than they realized.
Then, the pay down crisis begins, and personal spending options are delayed for years!
The better option to pay for emergencies or any unexpected expense is to use cash. There is no interest expense attached to cash!
However, cash will be available only if you have developed the habit of saving. That means being consistent with deposits to savings from every paycheck.
Granted, you will experience the unexpected expense. Machines, like appliances, mowers, and vehicles will need maintenance. If you have cash on hand, you will be more likely to do regular maintenance. There will be fewer “emergencies” in your life if you plan on paying for maintenance.
In my eBook, Saving, The Day!, available on Amazon Kindle, I show some calculations and the long-term effect in the use of cash over credit cards to fund emergencies.
The point to remember is that it is better to have interest income with savings and investments than to add interest to a debt, which represents an item or service you purchased but have not paid for yet!
Due Diligence with Debt
In my next post, Money Math – Part 3, I will help you use due diligence to identify some useful debt and how to reduce your exposure to interest expense.
There are many more formulas and measures to cover with the focus of alerting you to how to build a better mindset for money!