Finance 101

I'm frustrated with the presidential campaign. I don't think either candidate has an effective plan for the future. I don't believe either of them will actually be able to lower taxes as they both promise and you know how I stand on the plans anyway. I don't want to dwell on it tonight so I'm going to post about the first lesson I'm going to teach in my future finance class.

Any finance class has to have some semblance of order, but before that there has to be a bit of excitement. Finance is nothing if not exciting so my first lesson will be about the future value of an investment, more specifically, the Future Value equation.

FV = PV*(1+i)^t

Big deal right? This equation is learned in Algebra class in middle school or high school and the wow factor lasts about 15 minutes. What happens when we apply the equation to a real life scenario regarding automobile purchases?

Let's take the example of a $15000 car bought with a loan at 6.6% over 5 years. That comes to a monthly payment of $295. The resultant cost of the car is $17700. Now let's say that instead of a $15000 car we decide to buy a $10000 car resulting in a monthly payment of 195. The resultant cost of the car is $11700. $1000 savings over 5 years in interest payments big deal, but if the $100 per month is invested in a mutual fund with an average gain of 10% per year the resultant sum after 5 years is $8000. In either scenario the car is paid off in 5 years and the layout in cash is $17700.

I'm going to say that the person buying this car is 22 years old so when the car is paid off the purchaser is now 27. Let's say that the $8000 was invested in an IRA and no further additions are made to the balance following the initial 5 year layout. At age 59 the balance is just shy of $200,000. If, however, the $100 monthly payment is continued to age 59 the balance becomes a not too shaby $472,187.

Just to take it one step further let's say that Joe Plumber continues to buy a new car every five years. He continues to pay $295 in monthly payments and his cars get progressively more expensive as he is able to place some money down from the sale of the previous car. At age 62 (used for calculation purposes) Joe Plumber has a pretty nice car free and clear.

Joe's brother Nate decides to eliminate his debt and at the end of 5 years he uses the sale of his car plus the $8000 saved to buy his next car with cash. At this point he places the whole of his monthly $295 into investments. At the end of 5 years his investment balance is $22843. He then takes $15000 to buy a new car with cash, but continues the payments to his investment account. After 5 more years the balance is $35748. Increasing the price of the new car purchase by $5000 every 5 years still yields a balance of $245,000 at age 62. If the price of the new car purchase is capped at $20,000 the investment account grows to an amount of $319,000 at age 62. Finally if the car purchase is pushed to 7 years instead of 5 the amount at age 62 grows to $481,786.

So that's half a million dollars saved just by buying slightly less expensive cars with cash as opposed to buying them on credit all thanks to the future value of money.

Now we get a little crazy, but to illustrate the equation we must continue.

Next we have Joe's other brother Tyson, who decides to bike to work and borrow Joe's car when he goes out of town. He places all of his monthly $295 into investments from the beginning. At age 59 Tyson decides to buy a $300,000 Ferrari 599 and be happy with the left over 1.1 million dollars still in his account.

Tyson's wife Cheryl doesn't have quite as much discretionary income as her husband so she only has $100 per month to invest. Having been born in Omaha, Nebraska she is a fan of Warren Buffet and decides to put her money into Berkshire Hathaway giving her an annual return of 21.1% (average annual gain from 1965 to 2007). She's not interested in cars, but has her eye on a 6.5 million dollar villa on the coast so she buys it with half of her $13 million at age 59. If only she had gotten Tyson to put his money into Berkshire he could be sitting on a ferrari 599 and $39 million. Oh yeah, none of those gains are taxed until sold because Berkshire doesn't give a dividend.

Finally we have Jonny who took the $8000 from our original example and put it all in Berkshire. Jonny didn't invest another penny his whole life yet 32 years later his 21.1% interest turned that 8 grand into $6.5 million.

I'm probably going to get some calls from angry parents after this lecture, but it will still be fun.