Archives For Time Value of Money

I was cleaning out my email inbox and found this email from way back in July:


I have a question. If a person owed money to someone in 1998, but did not repay that amount until 2010, how can he calculate what amount to return now (in 2010) considering that much inflation has taken place since 1998? Should he use the yearly CPI inflation rate for his country? Will appreciate your help. Thanks.

The amount to be paid back and the term of the loan should have been spelled out when the money was initially borrowed. Although the CPI can be used, it should be the beginning point. The person who loaned the money was out that money for the last 12 years. Paying back money with only an adjustment for the CPI is basically paying them back the original amount. To compensate them for the usage of the money, the borrower would need to include some percentage above the rate of inflation (the CPI in this case). I would say a good starting point is 2% over the CPI.

Basically, what that means is if this person borrowed $1,000 back in 1998, they should pay back around $1,726.93 at CPI +2% (or $1,351.59 just using the CPI for the last 12 years).

Check out this quote from a recent Wall Street Journal article by Andrea Coombes:

…about 40% of workers in their 20s and 30s said they had cashed out their 401(k)s or 403(b)s when they switched jobs, according to an online survey of about 1,200 people conducted in January for Fidelity Investments by CMI, a research firm.

Quiz time:

You quit your job and take a new job with a different company. You have $800 in your old company’s 401(k) plan (you had just started contributing). Do you:

1. Move the money to your new company’s 401(k) plan?
2. Move it to an IRA?
3. Cash it out because it’s such a small amount of money?

Of course options 1 and 2 are the best. Number 3 is the worst. But, how bad is it?

Well, for starters, your employer will have to withhold 20% of your $800 for income taxes. You will also lose another 10% due to the IRS’s early withdrawal penalty. So, your $800 becomes $560 by the time you actually receive it.

Now, what’s the opportunity cost for cashing out your 401(k)? As you can see from the following graphic, it can be a significant amount over a long period of time:

Don’t underestimate the potential growth of a small amount of money! Instead of looking at $800 as a small amount of money now, consider it’s future value if invested properly. And, if there’s ever a time when you are tempted to cash out your 401(k) in order to pay bills, fix your car, or take a vacation, PLEASE re-read this post!

With the last post, we figured out that four years of college was expected to cost $105,655. Now we need to know how to reach that goal.
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It is amazing how the math we all thought was useless back in high school is really pretty useful today. Understanding mathematical concepts is very important in understanding personal finance. It is also very liberating to be able to do different “complex” calculations with the aid of a spreadsheet.
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