First off, you use the RATE function when you want to calculate what rate of return would be required to meet a certain goal, based on a few assumptions. Let’s use the information from yesterday’s post:

Retirement Goal: $1,000,000
Years until retirement: 20 (240 months)
Current retirement account balance: $100,000
Monthly contribution amount: $500

You can set it up like this in Excel:

Then, to solve for the rate, you simply put your click on cell E1 and then choose Insert > Function from the menu. You should then see this:

If you don’t see the RATE function listed in the center menu, then you might need to select “All” from the drop down menu above and then scroll down in the main menu until you see RATE.

Once you click on RATE and then “Okay”, you’ll see a menu that looks like this:

Then, you simply fill in the information, referencing the appropriate cells like this:

Here’s a quick explanation of each input:

Nper – the number of periods involved in this example. It’s 20 years but we’re making monthly contributions, so it’s more accurate to use 240 months. So we reference cell C1 and multiply it by 12.

Pmt – the monthly contribution amount expressed as a negative number. Think of it like a cash flow amount. The $500 is flowing out each month. So, we reference cell D1 and multiply it by -1 to get a negative number.

Pv – the present value of the retirement account—again expressed as a negative number. We reference cell A1 and multiply it by -1.

Fv – the future value of the retirement account. This value is expressed as a positive number. We reference cell B1.

Type – input 1 if the payment is made at the beginning of the month or 0 or leave it blank if the payment is made at the end of the month. I chose the beginning of the month and therefore inserted 1.

Guess – (you’ll have to scroll down to see this input as it is located under Type) This function requires a rate guess in order work properly. The default is 10 percent. I left this blank.

After you enter all the necessary information, click “OK.” You should see .78%, although you might see 1%. In that case, simply go into cell format and change the number settings to two decimal places.

Also, the formula will give you a monthly return. To convert it to an annual number, simply convert the percentage to a decimal and raise that number to the 12th power. Like this:

Hopefully, if I have done a good job, you now know how to use Excel’s RATE function. If you have any questions, please feel free to leave a comment.

Have a question:

What reasonable standards should investors use to measure how well or poorly that they are doing?

I’m sure that an answer would include “it depends” but if so, depends on what?

We are about 10% under our 12.31.07 balances and we are pleased but how pleased should we be? There is always someone who well fare better or worse but I’m at a loss as to which reasonable “standards” that I should use to know how I’m doing?

That’s a very good question.

Unfortunately, the appropriate answer is: it depends.

From a general standpoint, your portfolio’s performance should be judged against the appropriate benchmark or benchmarks.

For instance, if you have a portfolio of 50% large-cap stocks and 50% bonds, you would not base your performance on solely on the S&P 500 Index. Rather, you’d base it on a 50/50 split between the S&P 500 Index and the appropriate bond index.

If your portfolio is comprised of large-cap, mid-cap, small-cap, bonds, and real-estate investment trusts, then you need to base the performance on benchmarks for all of those asset classes.

The reason for this is that it’s easy to say, “Wow! We did awesome last year. Our portfolio was up 8%!” The reality could be that a benchmark portfolio might have been up 12%, making your 8% return not so stellar.

Of course, another way to judge your performance is to do what BG suggested in the comments of that post and that is to base your performance on whether or not you’re meeting your future goals. It doesn’t matter how your portfolio is doing if it’s not helping you meet your future goals.

For example…

Let’s say you have a retirement goal of $1,000,000 (purely hypothetical, ignoring inflation). Your retirement is 20 years away and you have $100,000 saved up so far. You are contributing $500 per month into an S&P 500-based fund. You don’t expect your contribution amount to change (again, hypothetical).

Using the RATE function in Excel, I figured that the required rate of return to meet that goal is .78% per month (9.79% annualized). Given that the monthly geometric average total return on the S&P going all the way back to 1926 is .77% (9.64% annualized), you most likely will fall short of your goal by around $25,000.

This leaves you a few choices:

1. You can accept the lower amount at retirement.

2. You can take on more risk by moving into small cap stocks, which have a higher expected return but also are a lot more volatile (more on that in a future post).

3. You can increase your contributions. Based on my numbers, increasing the contribution amount to $540 per month, put’s the expected account value at a little over $1 million.

I realize that we are talking about math based on linear growth, which never happens in the real world. But, it can still be beneficial to have some sort of basis in reality. If your goal is $1 million and you’re investing a certain amount per month, it would be wise to know if you have a shot at meeting your goal.

Thoughts?

I have never counted myself among the Dave Ramsey fans. Sure, his advice is better than racking up lots of debt and not saving for the future. But, he also generalizes and has a one-size-fits-all approach to the advice he offers his listeners.

What bugs me most is the math behind his assumptions.

For example…

On page 3 of the above-mentioned workbook, is this:

“The American Dream

Imagine if…
A 30-year old couple made $48,000 a year and saved 15% ($7,200 per year or $600 per month) in a 401(k) at 12% growth.

At 70 years old, they will have…
$7,058,863.50 in the 401(k)”

How did Dave arrive at that number? Here’s the math:

That’s a lot of money!

But, how would this look in the real world? I summarized Dave’s information into the following graphic and used 2009″s numbers from the IRS to calculate income taxes.

For my example, I assumed that this couple does not have children. If that were the case, it would probably be possible for them to sock away $7,200 per year. Their budget would be tight unless they economized.

Then comes my next question:

WHERE ARE THEY GOING TO GET A 12% RATE OF RETURN FOR 40 YEARS?

Seriously, WHO assumes a 12% rate of return for 40 years? Later on in the book, Dave stresses diversification. There’s not a properly diversified portfolio on earth that is going to average a 12% rate of return on a consistent basis. The ONLY way you’re going to get that kind of return is to invest ALL YOUR MONEY in small cap stocks, which are highly volatile.

I think the word “imagine” was the proper word to use for his scenario because the only way he’s going to get those numbers is with IMAGINATION!

To bring us back to REALITY, I reran Dave’s numbers using a much more conservative .77% monthly rate of return, which happens to be the geometric average return for the S&P going back to 1926. Take a wild guess at what the 401(k)’s expected value becomes with that number?

And that number’s even somewhat inflated because it assumes 100% of the money is invested in the S&P for all 40 years.

And…

Neither of those numbers include inflation, which would eat up at least half of those accounts.

So why does Dave use such a high number for an assumed rate of return? I would have to say it’s to give people hope (a false sense of hope, but hope nonetheless). When people look at those numbers, they go, “WOW! I can do that? I had no idea!” I will admit, that those numbers are eye-popping.

But,…

Thoughts?

I got the idea for this post after putting together yesterday’s post about eating out.

In the Excel spreadsheet I used for that post, I had a list of dates along with the name of the restaurant and the amount spent like this:

Fig. 1

As you can see, the list is in chronological order. I wanted to see how many times and how much we spent (the subject of another post) at each restaurant. I could have simply used the sort feature by highlighting the data and sorted them based on the restaurant name and then counted them that way.

I could have. But, there’s a better way…

Excel has a COUNTIF function that will count items based on the parameters you provide. It’s a really cool feature. I wanted Excel to count up the number of times we ate at each restaurant so that I could arrange it in a list insert it into yesterday’s post. To use the COUNTIF function, do this:

1. Figure out where you want to put your list. I decided to put my list in column D, E, F, and G like this:

Fig. 2

2. Create the list of restaurants that you want to count. I used the data sort feature and sorted the data by restaurant name and then made the list from there.

3. Determine and click on where you want the COUNTIF function to put your information. For my list, it was column E (cell E2), which I titled “#”.

4. Then click on Insert on the menu tab and scroll down to Function:

Fig. 3

You should be seeing a popup like this:

Fig. 4

Where it asks for range, you’ll need to enter the range from where your information will come from. NOTE: You’ll notice the “$” around the column letters. This fixes the range so that you can copy and paste the formula for each of the restaurants in the list.

Then, where it asks for Criteria, you simply choose the cell with the restaurant name that you want to count. In this case it is cell D2, which contains “Buffalo Wild Wings Beaumont.” Then click on “Okay.” If everything is done properly, you should see the correct count of all the cells containing “Buffalo Wild Wings Beaumont,” which is 3 in my example.

5. Simply copy cell E2 and paste it in the rest of the D column until the list is complete. It should look something like this:

Fig. 5

Next time I’ll show you how to use the SUMIF function.

Any questions? If so, leave a comment or send me an email and I’ll see if I can answer them.

It’s a fairly simple calculation to perform as long as you have the following information:

1. Number of days that have elapsed so far this year. This is easy to calculate if you have access to Excel.

2. The YTD return of the investment that you want to annualize.

The formula for annualizing a ROR is pretty straight forward:

The YTD ROR should be expressed as a decimal. Plugging in the Vanguard S&P 500 Index Fund information from above, the equation looks like this:

So, a 12.07% loss for the first 204 days of the year equates to a 20.47% loss on an annualized basis.

Now let’s say you are down 12.07% but you purchased this fund on December 31, 2006. How do you annualize that return? The only input that changes in the above formula is the number of days, which is now 570.

Had you purchased an investment on December 31, 2006 that is currently down 12.07% since the time of purchase, your annualized rate of return on that investment would be -7.91%. Not much of a return is it? Anyway, now you know how to annualize your returns. Fun stuff!

But then I noticed something that I never really noticed before (I noticed it before but never really thought about it): My extra payments wouldn’t save me that much in interest. Why? Well, it has to do with the way loans are structured. When you take out a loan, the payment is calculated based on the length of the loan, the interest rate on the loan, and the amount of the loan.

For example:

I’ll use our Honda loan as an example. Here’s the necessary information:

Interest Rate: 7.3645%
Period Rate: 0.6137%
Loan Term (Years): 3
Payments per Year: 12
Total Number of Payments: 36
Amount Financed: $15,019
Payment Amount: $466.26

Here’s what the amortization for this loan looks like (you can click on it to see a larger version):

Take a look at the first payment:

The beginning balance is $15,019. The interest portion of the $466.26 payment is $92.18 which is calculated by multiplying the beginning balance ($15,019) by the periodic rate (0.6137%). The remainder of the payment is applied to the principle, which becomes the beginning balance of the following month.

Each month the balance on the loan decreases, which makes the periodic interest payment smaller. This leads us to the point of this post:

In order get the most benefit from making extra payments on a loan, you need to make them at the beginning of the loan. How much difference does it make? Let’s see.

I ran two scenarios. The first one assumed an extra $50 each month for the final 18 payments and the second scenario the extra $50 was applied to the first 18 payments. Here’s what the two amortizations look like:

Under the normal amortization for this loan, the total interest charges for this loan would be $1,766. By making extra payments at the end of the loan, you would pay $1,720 in interest, giving you savings of about $46. By making extra payments at the beginning of the loan you save $155 in interest. No, it’s not a lot of money, but this is a short-term loan. Imagine how much the saving would be if this were applied to a mortgage.

Of course there are other things to consider when doing this math. For instance, you have to look at the opportunity cost of the $50 you are putting towards paying off the loan early. Could you put that money to better use elsewhere? That’s something you have to ask yourself.

Anyway, the next time you are tempted to accelerate the payments on a loan, ask yourself how much you are actually going to save by paying it off quickly. You might be surprised to find out it’s not as much as you thought.

In your opinion, what’s the most confusing aspect of personal finance?

What area gives you the most trouble?

Several commenters stated that they had problems with trying to determine how much they needed to save for retirement.

That’s a tough question for a variety of reasons:

1. Retirement may be decades away. AS quickly as things change from one day to the next, it’s extremely difficult to imagine what the future will be like decades away.

2. Nobody knows what inflation will be like over the next few decades. A gallon of milk is around $4 today. At an inflation rate or 3%, that same gallon of milk will cost over $7 twenty years from now.

3. Expected rates of return are hard to determine. If you’re too conservative and use a lower expected rate of return, your calculations will tell you that you need to save lots more. On the other hand, if you’re too liberal and expect a rate of return that’s too high, your calculations will tell you need to save too little.

4. Nobody knows how long retirement will last. It could be five years or it could be forty years.

5. What will happen with Social Security? Although I’m not expecting Social Security to vanish, I do expect to have to wait longer to get a REDUCED benefit. It stinks, but I don’t see any way around it. That’s why I don’t include Social Security in my retirement analysis. If I get some, great. If not, I’ll be ticked, but I’m at least prepared.

6. Nobody knows what taxes will be like in the future. If I were a betting man, I would say that tax rates will be higher in the future.

7. It’s hard to balance today’s needs with the needs of the future. Let’s face it, we all want to enjoy life today without sacrificing the future.

STEP 1

So, where do we start?

Personally, I think the place to start is by looking at your current situation. Ask yourself these questions:

Do I make enough today to provide for all my needs?

Realistically, how much more do I need to make in order to put myself financially comfortable situation?

I use the word “realistically” because we would all like to make $1 million per year. However, for most of us that just isn’t realistic.

If the answer to the first question is yes, then take that number and project it into the future using an expected inflation rate. For example: say your current taxable income is $75,000 per year. We’ll assume that you are happy with that number and feel that you could have a comfortable retirement on $75,000 per year (in today’s dollars and excluding Social Security).

The next step is to then look at a range of possible inflation rates to get an idea of what amount will equal $75,000 in today’s dollars sometime in the future. For instance, let’s say you are 30 years from retirement and expect inflation to run between 3% – 4% over the next 30 years. Using the future value formula, we can calculate the future value of $75,000 at both 3% and 4% inflation rates like this:

At 3% inflation…

FV = $75,000 × (1 + .03)³⁰

FV = $75,000 × (1.03)³⁰

FV = $75,000 × 2.427262471

FV = $182,045

At 4% inflation…

FV = $75,000 × (1 + .04)³⁰

FV = $75,000 × (1.04)³⁰

FV = $75,000 × 3.24339751

FV = $243,255

It’s seems crazy to think that someday it will take $182,045 just to equal what $75,000 buys today. That’s inflation for ya! Anyway, according to those numbers, we are looking at a range of $182,045 and $243,255.

STEP 2

So, we have an idea of our future income needs. Now we need to figure how big of an account we need in order to generate that kind of income. There’s a couple of ways to do this. The first one assumes that you don’t want to touch your capital base so that it can hopefully grow each year, giving you a bigger base with which to withdraw from in the future. This is the most conservative method. It’s also going to require A LOT more money.

Here’s how it works. Let’s assume that you don’t want to withdraw no more than 4% to 5% per year. You simply divide your withdrawal rate into your income needs to get your capital base. Like this:

$182,045 ÷ .04 = $4,551,117

$182,045 ÷ .05 = $3,640,894

$243,255 ÷ .04 = $6,081,370

$243,255 ÷ .05 = $4,865,096

So we’re looking at needing a capital base of $4.5 million to $6 million if you don’t want to withdraw no more than 4% per year. Theoretically, as long as your portfolio returns more than 4% per year, you shouldn’t run out of money (assuming you don’t withdraw more than 4% of your portfolio’s value). It also means that you will have a pretty good chance of being able to leave an estate to your heirs if that’s important to you.

Another method is to use the retirement savings calculator I put together a couple of years ago. I had forgotten that I had created this calculator until I found it while looking through my Excel spreadsheets. This calculator is one of my favorites because it was one of the most challenging to create.

The calculator is composed of two parts: the input page and the print out page. Both pages work hand-in-hand. Using the numbers from above, we can input the following information:

Current Age: 35
Retirement Age: 65
Expected Length of Retirement: 25 (in other words, you expect to die at 90)
Current Income: 75000
Desired Assets to Leave to Relatives/Charity: 250000
Amount Currently Saved: 100000

All the other blanks should already be filled in for you. You can, however, make changes and run different scenarios. For instance, if you didn’t want to leave anything to charity, you could put 0 in that blank. I would recommend against this because the amount in that box could be your safety net in case you live longer than 25 years in retirement.

Anyway, this calculator tells you that you need a little over $3 million at age 65. Why is this amount so much smaller than amounts we found previously? Because this calculator assumes that you are spending down your principal during retirement. IMPORTANT NOTE: this calculator also assumes linear (or straightline) growth during both the accumulation phase and the distribution phase. We all know that we don’t live in a linear world. That said, it’s still a decent way to look at retirement planning.

So there you have two ways to help you determine how much you need at retirement. Yes, they both work off a lot of assumptions, but I’m afraid that’s the best I can do. There’s just too many variables to get it nailed down any harder than what we just looked at. One thing you can do is look at these numbers once a year to see how you are doing. If it looks like you are going to fall short or your needs change, you can make adjustments.

There’s more to this. Next time, I’ll talk about figuring out how much you need to save each month in order to reach your goal. Until then, please feel free to offer up any comments or suggestions about today’s post.

One of the sections of the book that I found most interesting was this illustration of probability on page 151:

A lottery has 100 tickets. Each ticket costs $10. The cash prize is $500. Is it worthwhile for Mary to buy a lottery ticket?

The expected value of this game is the probability of winning (1 in 100) mulitiplied with the prize ($500) less the probability of losing (99 out of 100) mulitplied with the cost of playing ($10). For each outcome we take the probability and multiply the consequence (a reward or a cost) and then add the figures. This means that Mary’s expected value of buying a lottery ticket is a loss of about $5 (0.01 × $500 – 0.99 × $10).

He goes on to say…

Mary has a 1% chance of winning the lottery and if she wins, her gain is $490. She has a 99% chance of losing $10.

What happens if Mary buys 10 tickets?

If Mary were to buy 10 tickets, she would have a 10% chance of winning and her gain would be $400. She has a 90% chance of losing $100.

I don’t think I would play this lottery!

This is a very simple example but interesting nonetheless.

I always wondered about this stuff but never gave it much thought. I actually hated stats class in college. I had to take three semesters of stats because the one semester I took in college in Kansas wouldn’t transfer to my college in Texas. To top it off, the Texas college required TWO semesters of stats. Lovely! I just wish I would have paid more attention in class!

It’s not my intention to turn this into a statistical blog, but I do hope to explore this topic some more in the future.

I recently heard about a loan company that specializes in short-term loans. Here’s a typical example of a loan that this company offers:

Loan Amount: $1,250
Loan Term: 36 bi-weekly payments (72 weeks)
Payment Amount: $91.66
Total Payments: $3,299.76 ($91.66 × 36 = $3,299.76)
Total Interest: $2,049.76 ($3,299.76 – $1,250 = $2,049.76)

What’s the APR?

171.54%!!!!!!

Now I’ll show you two ways to calculate the APR on this loan.

Here’s how the APR is calculated using a financial calculator:

N = 36
I/Y = ? (remember that you will need to change the P/Y to 26 since they are bi-weekly payments)
PV = $1,250
PMT = $91.66 (entered as a negative number)
FV = 0

Then you simply solve for I/Y by pressing the CPT button followed by the I/Y button. Your answer should be 171.54.

You can also calculate the APR with Excel, using the RATE formula and inputting the numbers like this:

You then need to multiply the answer (0.065977) by 26 to get the APR, which should be 1.7154 or 171.54%.

Now, here’s what an amortization schedule looks like for this loan:

It’s amazing to think that 90% of the first payment goes to pay interest!

One would have to either be desperate or uneducated to agree to these loan terms. Needless to say I won’t be advertising for this company.

Lets take a look at the numbers using my age (38) as the basis for the calculations. If I’m lucky enough to live to age 100, that’s about 62 years from now (or 3,224 weeks). If I were to win PCH’s prize, I would receive $16,120,000 in income over my lifetime:

WOW! The only problem is, I left out two VERY IMPORTANT details:

1. Taxes

2. Inflation

The IRS wants their share and will withhold 25% of each check. So, from day one, you’ll be receiving $3,750 per week. In addition to that, the $3,750 per week stays the same dollar amount over your lifetime. Everyone knows that a dollar today is worth more than a dollar at some point in the future due to inflation. So, that means that inflation is going to eat into each of those $3,750 checks. In ten years that $3,750 will only have the purchasing power of $2,778 in today’s dollars. Using the numbers from the example, my last check (check #3224) would only be worth $583.46 (and that’s assuming 3% inflation. If inflation runs higher than that, the money will be worth even less).

Of course, there are ways around some of this. For instance, let’s say you are able to save 10% each week ($375 per week) for 42 years. During this time, you invest your weekly saving in an S&P 500 Index fund (like the Vanguard S&P 500 Index). Assuming a straight-line 8% return (.15% per week), at the end of 42 years, you would have an additional $6.77 million, which would be worth approximately $2.8 million after inflation.

So, it would definitely be to your advantage to save some of your winnings.

It’s fun to dream about winning the lottery but the winnings are never as good as they make them out to be.