Simple Cents University: Compounding Interest

The reason that time is such a powerful player in the world of personal finance is because of compounding interest. Compounding interest is the money you earn, by letting someone else borrow your money. Why else would you put a bunch of money in the bank, unless they paid you for doing so?

For example, say you invest $5,000 in a mutual fund. Mutual funds have typically provided 10-12% return in interest. We'll use 12% interest for this example. Let's look at this money over the course of a few years:

1. $5,000 @ 12% = $5,600 : Net Change = $600
2. $5,600 @ 12% = $6,272 : Net Change = $672
3. $6,272 @ 12% = $7,025 : Net Change = $753
4. $7,025 @ 12% = $7,868 : Net Change = $843
5. $7,868 @ 12% = $8,812 : Net Change = $944
6. $8,812 @ 12% = $9,869 : Net Change = $1,057
7. $9,869 @ 12% = $11,053 : Net Change = $1,184
8. $11,053 @ 12% = $12, 379 : Net Change = $1,326
9. $12,379 @ 12% = $13,864 : Net Change = $1,485
10. $13,864 @ 12% = $15,528 : Net Change = $1,664...

As you can see in this example, in only 6ish years, you have doubled your investment. In 10ish years, you have tripled your investment. To continue this example (without all the typing), at year 20 the investment would be worth over $54,000. After 40 years, you would be carrying around $593,000! And it all began with $5,000 and a little bit of interest.

Another note worthy point for all the nerds out there - because you are dealing with percentages (i.e. 12% interest), the Net Change in the value of your investment grows at an exponential rate for as long as the money is invested. Thus, the get'n keeps getting good'r.

Just imagine, paying $11,000 dollars for a $20,000 car. Now that is a heck of a deal. All you need is 5 years of planning. Or setting $5k aside when your child is born and having college paid for. These are just a few great examples of the power of compounding interest and saving with a plan.

George's Advice

Yesterday, I stumbled upon this fantastic George Foreman quote:

"The question isn't at what age I want to retire, it's at what income."

Most people you speak with, concerning retirement, all echo the same spirit. Things like: I will never get to retire; I will have to work forever; and I wish I had started saving sooner. This hum-drum attitude is far too common in the world we live in.

I love this quote because it is powerful on two levels. On the surface, it speaks regretfully to the person who is nearing retirement age. It says, keep working so that you can retire with comfort.

But I think this quote also speaks to the twenty-somethings. To this crowd it speaks optimistically, encouraging a life well planned. The twenty-somethings of today have no hope for social security or pensions. That just isn't in the cards. But they do have hope in something many of their parents will never have again - 40+ years of life left in front of them.

To the youth of today, I preach a message of saving. Not saving to horde your money, scared to ever spend a dime. No. I propose saving with a plan.

Ex. You want to save 1 million dollars in mutual funds for retirement. Here are two options that will both net the same end result.

• You could save $90 per month for 40 years.
• You could save $1,100 per month for 20 years.
  

In the world of personal finance, time is the most powerful influence - arguably more so than income. To today's youth, time IS money. So get a plan, and start saving. Otherwise George may punch you in the face with his lean, mean, grilling machine!

Escrow's Helping or Hurting [simplesaving]

Allowing your bank/lender to set up your property tax escrow account is almost an "automatic" at any closing. Really, this is only necessary for the individual who lacks the discipline or savvy to handle it himself. By closing your escrow account with your mortgage company (this can be done at any time during your mortgage), you begin to become "your own banker." Set up an automatic withdrawl out of each paycheck to be send to a high-interest savings account. Then you, not your banker, are making the interest off of your money for 12 months. While this might only mean 50-75 bucks, the process begins to cause you to approach other areas with a different mindset. This is a simple, yet common, example of making interest work for you.

Simple Cents University: The FICO Score

Much is made of the great FICO Score (aka your credit score). For years, scientists have worked in rooms without windows, attempting to create the perfect credit score. So what is this mythical creature and why is it important to us regular folks?

Years ago, in a land far far away, lending officers (the people in the bank that reside in the glass offices) actually worked for a living. I know it is hard to believe, but its true. When an individual came into the bank, looking to borrow money, the lending officer would spend time researching the person - their job, their reputation, their financial status, etc. The lending officer would use this information, along with rational thought (which has since become extinct), and determine whether the person was fit to borrow money and the likelihood of them repaying the loan. This information would be compiled and used to determine how much the bank would lend the individual, if at all.

Well...then came computers. And with computers came 'data'. You see, computers don't think rationally. They only store data. Bankers needed a method to standardize & mass produce this lending process and be able to store the corresponding 'data'. [Enter: FICO score.] Named for the firm that developed the process, the FICO score in generated by a mathematical formula (something a computer can do) to provide the general credit worthiness of an individual. The formula based off of information found in your credit report - simply an individuals log of all things financial. A weighted scale of five financial factors combine to derive the FICO score. The breakdown of these factors is found above. Scores range from 300 - 900. Most folks fall in the 600-750 range.

There are three agencies that provide this mathematical decision making: Equifax, Experian and Trans Union. Now days, when banks make lending decisions, they use these 'credit bureaus' to automate the decision making process. This means roughly 75% of the time, everything makes reasonable sense. However, since there is no rational human behind the process, 25% of the time a dart-throwing monkey could provide the same service.

Example: A company owner who makes well-in-excess of $100,000 dollars a year applies for business credit cards for her company. As the owner of the company, her credit report is used to establish the credit limit on the company credit card account. Visa, via an Equifax report, denies her request for a $50,000 corporate credit limit (less than 50% of her annual income and far less than the average net profit of the company). Meanwhile, I (a person who makes no where near that much money) regularly receives pre-approved credit card offers for well-in-excess of 50% of my income. What gives? The FICO monkey strikes again.

Note the breakdown above. The FICO score is comprised of a person's debt history. If you don't borrow money, your FICO score is penalized. Subsequently, the FICO score says you must consistently borrow money, if you want to borrow money. That's a little-bit stupid.

Most people only feel the FICO effects when they are applying for home loans or financing automobiles. Although most lenders lean on the FICO crutch, some folks still lend the old fashion way. If you are anti-debt, find a mortgage company that does 'manual underwriting' (old fashion lending). As far as cars, if you pay the note off in a timely manner, you will hardly notice the deference in FICO scores.

How do you check your FICO digits? By law, everyone is entitled to check their credit report (for free) once a year - per credit bureau. This will provide you a copy of the finance log on file at the corresponding bureau. Everyone is also entitled to one free annual credit score report. To check your score and/or reports, I recommend AnnualCreditReport.com. Despite the catchy tunes of FreeCreditReport.com, the aforementioned source, AnnualCreditReport.com, is the official government-sponsored source for the free reports. Personally, I check one bureau every 4 months. This allows me to monitor my reports all year long, without incurring any costs. Nifty huh?

"5 Basic Guidelines for Managing Your Finances" by Ron Lieber

Ron Lieber, writing for the NY Times, authored an article entitled, "5 Basic Guidelines for Managing Your Finances". In trying to boil the bubbling world of personal finance into 5 basic guidelines, Lieber provides an interesting article, albeit I believe 3 guidelines would have sufficed.

Lieber's Guidelines are as follows:

1. Investing is Simple - To this point, I give a hearty amen. Investing is simple. It is much more simple than most people would have you to believe. Lieber suggests index funds and mutual funds as investment tools. These tools perform very well for most investors and are very easy to use & understand.
   
2. It Still May be Worth Paying for Help - Lieber makes a valid point here. Most investment professionals should be able to provide an additional 1% (or more) in return. I am just not certain that they would. In most areas of the financial realm, I am a small fish in a big-huge pond. Given my modest financial weight, I am not sure that I would receive the attention & respect that I would demand from a broker. Thus far, I have found this true in various avenues. Plus, I ultimately enjoy doing it myself, though not everyone does. In the end, to this I would cite Rule #3.
   
3. Peers May Know More Than Professionals - As a product of the College of Business, many of my college peers have become career professionals. I assure you, many of them have no idea what they are doing. I mean that as kindly as I can type it. However, many professionals are either misguided or poorly educated. My advice to this end, find professionals you know and trust. Friends, or references from friends, may provide the same level (or better) of advice without the costs.
   
4. Everything Can (And Should) Be Automated - Although I would encourage automating investing (automatic transfers to savings), this is simply a matter of preference. I would always warn against automating to ignorance. Always keep a hand in your finances.
   
5. Have The Talk - This is an interesting 5th point. I enjoy the vision behind it. As Social Security goes down the crapper, todays unprepared mid-aged will need to rely on something. That will most likely be family. I sure don't expect the government to pull any Social Security rabbits out of their hat. Planning for the future of your immediate family, may very well include the plans (or lack there of) of your parents & in-laws.
   

One other thing that impressed me about this article, it was written tomorrow. Where is the DeLorean when you need it?!

Abe's Advice

"You cannot build character and courage by taking away a man's initiative and independence. You cannot help a man permanently by doing for them what they could and should do for themselves." -Abraham Lincoln

What is simplecents.org?
Often times, the easiest way to explain what something is, begins with what it is not. We are not about getting-rich-quick. We are not about the latest trend in personal finance. We are not about graduate degrees, starched pants, & big-fancy words.

simplecents.org is about education, for the common man. We are common sense - bridging the ever growing gap between the common man and sound financial principals.

Why Personal Finance?
Because money can make dreams come true and control people's lives, provide security and make people paranoid, help people and destroy marriages. Money is a big deal - for better or for worse. Unfortunately, the common man is losing the battle. There is no rational voice of education with the marketing budget of Visa. We certainly don't have the advertising budget of Visa, but we are hoping to be a rational voice of education & information.

Why is this important?
Because there is no one out there who will do it for you. No government, no book, no infomercial, etc. You are the only one who can make the difference. You are the only person you know who can alleviate the fear & frustration caused by financial confusion. We are the one, and we are here to help - help you "permanently" "build character and courage".