By: Laura Walton AFC®
Good math skills + good behavioral choices = good financial outcomes…but we struggle with both. Statistics show that two-thirds of us are poorly prepared to make good financial decisions!
The National Assessment of Educational Progress, aka the Nation’s Report Card, tells us that just 37% of American high school seniors were academically prepared for college math and reading in 2015 while the Marshmallow Study suggests that just about the same percentage of us are good at delayed gratification.
That leaves two-thirds of us wishing that we weren’t quite so impulsive and had better math skills.
BusinessInsider.com reported on “11 Personal Finance Equations You Need to Know”. These 11 equations would test the math skills of most of us to the limit. Fortunately, we are in the age of online calculators – an easy alternative to tough math. Let’s look at a few of the equations and how they relate to daily personal finance decisions:
Cash flow: This seems so obvious but lots of folks don’t take the time to compare their income to their expenses until they’re feeling the pinch of credit card debt. We know that if we spend more than we make we can’t save; if we don’t save, we can’t invest; and if we don’t invest, we’ll be dependent on social security when we retire or, as Dave Ramsey says, we’d better like cat food. Cash flow = Income minus Expenses
Simple interest: Looking at how much interest you pay in a year if you carry a credit card balance can be a persuasive argument to pay it off. As of 2015, households that don’t pay off their credit cards each month carry an average balance is $15,762 at an average interest rate of 18% for an average interest cost of $2837 per year ($15,762 x .18 = $2837). I can think of better ways to spend $2837! Simple Interest = Principal x Interest rate
Credit card equation: How long will it take to pay off your credit card? This is the most difficult equation cited so let’s turn to an online credit card calculator. In the credit card example above, $630 is the required minimum payment. If, instead, I paid $750 a month, the balance would be paid off 6 months sooner (26 versus 32 months).
Cost of borrowing: The average car loan today is written for 6.5 years! How much more interest do you pay compared to a 4 year loan? This online auto loan calculator will tell you that for a $20,000 loan at 4%, you’ll pay an additional $1070 in interest. And, you run the risk of owing more than the car’s worth before you pay off the loan. Consider the motive – the car salesman is trying to make the loan payment affordable for you by extending the term.
For mortgages, www.mtgprofessor.com has excellent tools.
Compound interest: We encourage young adults to save early because the effect of compounding interest is so powerful. We talk about saving $30,000 by age 30. Assuming no further contributions and an 8% rate of interest, at age 65 the balance is $443,560. Again, turn to this online investment goal calculator.
But what if you can contribute regularly to an investment account? This same calculator tells us that if our goal is to have a balance of $1M at age 65, we need to contribute $465 a month from age 30 to 65 assuming an 8% rate of return.
This calculator can also adjust for the rate of inflation and your federal and state marginal tax rates.
Debt ratios: Lenders use these calculations to determine if they’ll lend to us and, if so, how much. The mortgage payment (PITI) divided by your gross monthly income shouldn’t exceed 28% while the mortgage payment (PITI) plus all other contractual debt payments divided by your gross monthly income shouldn’t exceed 36%. Given $60,000 a year in income, your mortgage payment (PITI) shouldn’t exceed $1400. If you have other debt (car loan, credit cards, student loans, etc.), you may exceed the 36% benchmark. Bear in mind that, among other things, this calculation doesn’t take into account the number of children you have. This is why you might qualify for a mortgage that, in reality, you can’t afford!
The Rule of 72: This is a fun one! It tells us how many years it will take our money to double at a given rate of interest. For example, at 8%, divide 72 by 8 and you’ll find that your money doubles every 9 years.
I could go on but we’ve all had enough math for one blog. The point is that so many of our decisions are based in math and we have great online calculators to help us. The math tells us what our alternatives are which is what we need to know to make sound financial decisions…as long as the car salesman doesn’t tempt us with the latest, loaded model and that impulsive behavior I mentioned kicks in!