Financial Life Coaching

Lesson Four:

Time Value of Money

David Murphy, Ph.D., CPA, CFP®

Introduction:

I. The Bible and Interest

A. Parable of the Ten Talents (Matthew 25:14-29)

B. Usury and Interest (Leviticus 25:35-37)

II. Tool or Enslaver

A. Tool

B. Invest $1,000 at 5% Interest Today.

C. How Much Will You Have in Five Years?

III. The Talent Principle

Year Amount

A. $1,050.00

B. $1,102.50

C. $1,157.63

D. $1,215.51

E. $1,276.28

F. $1,340.10

G. $1,407.10

H. $1,477.46

I. $1,551.33

J. $1,628.89

K. $2,653.30

L. $4,321.94

IV. Enslaver

Owe $9,000 on an 18% Credit Card and Make the Minimum monthly Payment of 1.5% or $10

How Many Months to Pay Off the Credit Card?

V. Financial Slavery

A. You Would Pay Off the Credit Card in 960 Months

B. 80 Years

C. $129,600 in Interest

VI. Inflation

A. A General Increase in Prices

B. Everything, Except Money, Becomes More Valuable (More Expensive)

C. Historic Inflation Rates

Average Inflation Rates:

Time Period Average Inflation Rate

1913-2004 3.14%

1945-2004 4.12%

1950-2004 3.93%

VII. Cause of Inflation

A. Increase in the Money Supply

B. Isolated Island Economy

1. One product – grass skirts

2. Production – 100 skirts per year

3. Money supply – 100 conch shells

4. Price of one skirt – 1 conch shell

C. What Happens if the Supply of Conch Shells Doubles?

1. Inflation – the price of grass skirt would increase to 2 conch shells per skirt

VIII. Inflation – The Bad

A. Prices Increase Faster than Salaries

B. Strain on Family Budgets

IX. Inflation – The Good

A. Debts are Repaid with Cheaper Dollars

X. Understanding Interest

A. Principal

B. Interest

C. Interest Rates

D. Nominal Interest Rate

E. Periodic Interest Rate

F. APR

XI. Interest and Principal

A. Principal – the amount of money borrowed or lent

B. Example – if you borrow $1,000 then the principal on the loan is $1,000

C. Interest – the amount paid or received as a fee for borrowing or lending money

D. Example – if you borrow $1,000 and have to repay $1,100 then the interest on the loan was $100

1. Interest rate is usually determined by and percentage rate

XII. Interest Rates

A. Interest Rate = f(Inflation expectation + risk)

B. Nominal – Interest rate stated on the face of a loan document

C. Periodic – A rate of interest applied to a loan or credit card that is calculated for a time period other than a year, such as weekly, monthly or even daily

XIII. APR—Annual Percentage Rate

A. APR is Not the Face Interest Rate

B. The Following Fees ARE Generally Included in the APR:

1. Points - both discount points and origination points

2. Pre-paid interest

3. Loan-processing fee

4. Underwriting fee

5. Document-preparation fee

6. Private mortgage-insurance

C. The Following Fees are SOMETIMES Included in the APR:

1. Loan-application fee

2. Credit life insurance

XIV. Simple Interest

A. Annual Interest = Amount (Interest Rate) Time

B. Example

C. What is the Annual Interest on a $3,000, 12% Loan?

D. Interest = $3,000(.12)1 = $360

XV. Example

A. What is the Interest on a $5,000, 18%, 3 Month Loan?

B. Interest = $5,000(.18)(3/12) = $225

XVI. Pay-Day Loan Interest

A. Assume that a coaching client borrowed $300 on a “no-interest” payday loan that requires that $350 be repaid in two weeks. What is the annual interest rate on that loan?

B. Interest = Amount (Interest Rate)Time

C. Interest Rate = Interest / (Amount)(Time)

XVII. Interest Rate = $50 /($300)(2/52) = 4.33 = 433%

XVIII. Compound Interest

A. Interest on Interest

B. “The Most Powerful Force in the Universe”

XIX. Example

A. Invest $1,000 for Five Years with 5% Compound Interest . . .

Beginning End of

Year of Year Interest Year

1 $ 1,000.00 $ 50.00 $ 1,050.00

2 $ 1,050.00 $ 52.50 $ 1,102.50

3 $ 1,102.50 $ 55.13 $ 1,157.63

4 $ 1,157.63 $ 57.88 $ 1,215.51

5 $ 1,215.51 $ 60.78 $ 1,276.28

XX. Time Value of Money

A. Future Value = Present Value (Future Value Factor)

B. Calculating Future Values

C. Formula Approach

1. Future Value = Amount (1+Interest Rate)Time

2. Future Value = $1,000(1.05)3

3. Future Value = $1,000(1.15763)

4. Future Value = $1,157.63

D. Table Approach

1. See CD ROM disk—Future Value Table

2. Future Value = $5,000(1.276) = $6,380

XXI. Present Value = Future Value (Present Value Factor)

A. Calculating Present Values

1. Formula Approach

a. Present Value = Future Value / (1+Interest Rate)Time

b. Present Value = $1,000 / (1.05)3

c. Present Value = $1,000 / (1.15763)

d. Present Value = $864

2. Table Approach

a. See CD ROM

b. Present Value = $1,000(.864) = $864

XXII. Effect of Interest Rates

A. Assume that you must select between two different investment alternatives.

B. Investment 1 – $3,000, 10 year, 7%

C. Investment 2 -- $3,000, 10 year, 9%

D. What is the Differences in the Return On These Two Investments?

E. Hint – Use Table 2 from the CD ROM disk and compute the future values

XXIII. Effect of Interest Rates

A. Investment 1 -- $3,000 (1.967) = $5,901

B. Investment 2 -- $3,000 (2.367) = $7,101

C. Difference $1,200

XXIV. Effect of time

A. Let’s take a look at two brothers. The both graduated from college in engineering, got married right out of school and began their families. Bill scrimped and saved $1000 a year from the time that he was 25 years old until he was 65. He invested the money each year in a no-load mutual fund that earned an average 10% return. That means that he invested a grand total of $40,000 over those 40 years. Dick was more of a spender and didn’t want his family to miss out on anything. Consequently he didn’t start saving until he was 45 years old. By then the kids were out of the house and putting away $1,000 a year didn’t hurt nearly as much. Dick invested in the same mutual fund that yielded a 10% return.

B. How Did their Investments Turn Out?

C. Bill and Dick

XXV. Einstein and the Rule of 72

A. E = mc2

B. Rule of 72

C. Speaking of the Rule of 72 Einstein said “It is the greatest mathematical discovery of all time.”

D. 72 / Interest Rate = Time to Double Your Money

E. 72/5 = 14.4 years

XXVI. Annuity

A. Ordinary Annuity – An equal sum of money paid or received at the end of equal periods of time.

B. Annuity Due – An equal sum of money paid or received at the beginning of equal periods of time

C. Future Value of an Annuity Due

D. How much money would you have at the end of 10 years if you invested $2,000 at the beginning of each year for 10 years and earned an 8% annual return?

E. Hint – Use table A6

F. FV = $2,000 (15.645 ) = $31,390

XXVII. Why?

A. Interest is the Key to Financial Literacy

B. Answer Coaching Client Questions

C. Teach Clients to Use Interest to Make Wise Financial Decisions

XXVIII. Conclusion

XXIX. Resources

A. Time to pay off a credit card calculator available at Fox Business News at http://calcxml.foxbusiness.com/do/det01?skn=147

B. CD ROM – Time Value of Money Tables

C. CD ROM – Using a Financial Calculator