How Much is a Life Worth


In What is  Money, we discussed that

Money is time.

When you get a $20, you have in your hand a certificate for someone else’s time.   You could have someone cook and serve you dinner, change the oil in your car, or maybe give you a hair cut.   You get some of their time in exchange for the $20 you give them.  To gain that money in the first place, you probably used your time to do something for someone else.   To survive, you need to spend a good portion of your time gathering the things you need – food, clothing, shelter, security, warmth, transportation, etc….  You could buy or found a farm and use your time to provide these things directly, but most people instead do something they’re good at or that is easier for other people, trading that time for money, and then trading the money  for the things they need.

People are often free with their time but tight with their money.  They spend many hours doing things like fixing their car or doing home projects to save money, but they could have made more money at their job, plus perhaps gotten a promotion for putting in extra hours.  If you do these things because you enjoy them or because you can’t find someone else to do a good enough job, perhaps it is worth your time.  But consider carefully before you give up time, because the time spent doing things you are not good at and don’t enjoy is often not worth the money saved.
       

People also tend to be more giving of their time than their money.  You might not give a friend $500 to help hire movers, but you would probably spend a Saturday helping him move.  But what is that Saturday worth?  You could have spent it making $500 or more, especially if you have a job that lets you work extra hours for pay, or you could have been building or making something for yourself.  But most people would probably have just been watching TV or surfing the internet anyway, so spending some time helping a friend out, spending some time together, and perhaps getting help when you need it in the future, are worth the exchange.

One pet peeve of mine, however, is that those who give of their time are often expected to give their money as well, while others give nothing.  Often people who spend their time volunteering for a church event or to coach a group of kids in an activity are also left paying for supplies.  Why should the people agreeing to cook for the event also buy the ingredients?  It seems like people who are busy could donate the money for the food, while those who had the time could do the work.  instead, the same people usually end up doing both.  Any one else have this problem?

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If money is time, however, how much is your whole life, or a portion of your life, worth?  Before you say that a life is far more valuable than any amount of money, think about this:

If you were going to die in two weeks without a surgery that cost the $1 M that was your life savings, but the surgery would only let you live for one more year, would you do it?

I’m guessing that there are a few yeses out there, but that most people would say, “No.”  After all, you spent your whole life earning and saving up that money, and all of that time.  Why would you trade it for just one more year?  Especially if it was a year of pain, and perhaps a year of loneliness if you were very old and everyone else was gone.  Even if you didn’t have someone you wanted to give the money to, you would probably want the money to go to something else – something that was worth a decade of time or thirty years’ worth of time.  Not a single year.

In trials when someone dies, often the compensatory damages are in the $1-2 M range.  In a way this makes sense, given that someone who made the average wage of $50,000 and who worked for 40 years would make $2 M over that time.    Through his/her life he/she would have traded a great deal of time for about $2 M, so their heirs should receive about $2 M in compensation for the time that was taken.

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Probably the oddest thing about time is that people tend to value it less than money, at least when it is their money.  People will tell you that they would give anything for another day or even another hour, but people spend most days and hours finding ways to make time pass more quickly.  Who else could understand why people spend so much time playing solitaire on $800 smart phones when they could be doing all sorts of productive things?  People are always waiting for things, then waiting for those things to end, rather than seizing the moments that they have.

So maybe next time you find yourself sitting at home with a few hours before you need to go somewhere, maybe read a few chapters of Peter Lynch’s One Up on Wall Street and learn about investing.  Or maybe learn how to setup your cash flow to become wealthy instead of staying poor by reading Rich Dad, Poor Dad.  Or maybe even pick up a copy of the SmallIvy Book of Investing and learn how to use investing to grow your wealth.  Think of how much more you could do if you used the time you had – all of it.

           

 

 

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How Compound Interest Works Against You In Debt


As discussed in the last post, compound interest is your friend when it comes to growing wealth.  If you gain some cash through work and invest it, compounding will make it grow.  This will be slow at first, but in the end, your money will be making money, your interest earning interest, resulting in some really amazing amounts of growth.

Compound interest has a darker side, however, that happens when you get into debt.  If you start with a large balance like a home loan or a student loan, it keeps you from making any progress unless you really attack the debt.  More insidious,\ are loans that start out as small amounts and then grow with time, like small initial credit card balances where it seems like paying the debt takes nothing at all but then grow as you add purchases each month.  With these types of loans, if you let the debt get too large pass a threshold where all you’re paying each month is interest instead of paying down the balance, it can become totally unmanageable.  Let’s look at both of those cases and see what role compound interest plays in each.

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The Big Initial Debt

Remember that the effect of compounding is that interest generated causes your balance to grow, which in turn increases the amount of interest charged.  If you owe money, this means that you’ll be paying interest on your interest.  You are paying interest on money that you did not even get to spend on anything!

With a large loan like a home mortgage or a student loan, when you first start out and the balance is large, you’ll be charged a lot of interest each month.  This is because you interest payment at the end of each compounding period equals your interest rate times your balance for the period .  When you are first starting, the loan balance is big so the amount of interest you are charged is big.  When you nearly have the loan paid off, the balance is low so the amount of interest charged each month is low.  For example, if you have a home loan and your mortgage interest rate, i, is 12% per year and it compounds (charges you interest) monthly, for a $100,000 loan, B, the interest after the first month would be:

i/12*B = 12%/12*($100,000) = $1,000.

At the end of the first month, while you only borrowed $100,000 to start with, you’d now owe $101,000.  You owe $1000 just for using their money!  If you only paid $1000 as a payment for the month, your loan balance would return to $100,000, but then at the end of the next month, like magic, you would owe $1,000 again!  Your loan balance would never go down since the interest would build up each month by the time you made the next payment.

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A Growing Small Debt

Loans are normally designed to allow you to pay them off in a certain period of time.  For example, with a 30-year mortgage, the payments are designed such that if you pay the payment each month for 30 years, you’ll pay off the loan with the last payment.  For a 30-year loan with a 12% interest rate on a $100,000 home, the payment would be (use a mortgage calculator to run your own cases) $1028.61 per month.  Because you paid an extra $28.61 beyond the interest that built up at the end of the first month (remember you’d be charged $1000 in interest after the first month), your loan balance after the first month’s payment would now be: $99,971.39.  This is still a lot like $100,000, but at least you’ve made a little progress.  In the next month, you would only owe $999.71, so you would pay off $0.29 cents more of the principal owed on the loan with your $1028.61 payment, so your loan would be $28.90 after you made the second payment.  Each month after that you would be paying off a little more of the loan because you would owe a little less interest each month since the balance was shrinking.

Things to know when you’re paying off a big balance on payments:

1.  If you don’t pay at least the interest payment, your balance (and the amount of interest you are charged each month)will increase and you’ll never pay it off.  At 12%, the amount you owe will double every five years.  At 6%, this will happen every ten years.

2.  Paying more than the minimum due makes a huge difference at the start of the loan, but little difference at the end.  In fact, if you were to pay an extra $28.61 ($1028.61 for your first payment) in our example instead of just paying the payment due ($1,000), you would eliminate one payment entirely.  That $29 would save you $1,000 over the life of the loan.  Pay an extra $1,000 the first month, and you’ll save about 30 payments, or $30,000!   Pay your loan off one month early with an extra $1,000 at the end, and you’ll only save $10.

3.  The higher the interest rate, the higher your payments to keep the balance declining.  If you only had a 6% interest rate in our example, you would only be charged $500 in interest the first month, so as long as you paid more than $500, your balance would be declining.  You would also pay a lot less over the life of the loan.

4.  If you aren’t making payments, the loan balance grows really fast.  If you have student loans deferred or get a “free month” from your mortgage lender for making your payments on time, it means you will be paying interest on interest, where balances can really grow fast.

                                         

With a large loan you take on purposely, at least you know what your payments are and what you’re getting into from the start.  More dangerous is a small loan that you add to each month, because there the payment can grow quickly and overwhelm you.  That is why a lot of people go bankrupt due to credit card debt and consumer loans such as home lines-of-credit.  An additional factor in these types of loans, particularly credit cards, is that the interest rates are usually much higher than they are for home loans, are not fixed, and can even increase rapidly if you miss a payment or some other event occurs.  In such cases many credit card agreements allow the company to hike your rates up to 25% or more.

The interest works the same way with these loans as they did with the mortgage or student loan payments, where if the interest rate is 18% and you owe $1,000, you’ll owe $1180 at the end of the month.  The issue is that most people naturally will take on debt and payments until they have little or no free income at the end of the month — their paycheck equals their payments.   This means that if they need to pull out a credit card to cover an “emergency” like a car repair or a vacation, then they have a new interest payment for which they do not have any spare income to cover.  Also, if you’re already sending most of your take-home pay out each month, it is difficult to then start to pay down credit card debt, particularly when there is interest added on top.

Just as happened with saving and investing where you got very little in interest at the beginning when the account balance was small and a whole lot at the end when it was big, credit card interest payments will be small while the account balance is small. At some point, however, it can reach the tipping point where the interest amounts become really big and you struggle just to pay the interest, let alone pay down the debt.  Suddenly you’re just barely able to cover the minimum payment, which is mostly interest and barely affects the balance as was the case with the home loan.  If you then miss a payment or are unable to make the minimum, the amount you owe actually grows and the interest rate possibly jumps from 18 to 30% or more.  At that rate, the amount you owe will double about every two years!

Things to know to stay out of trouble with growing small debts:

1.  Just because the payment is small now, doesn’t mean it can’t become big quickly.  It is amazing how quickly a little, insignificant balance can grow.  There is a point of no return where the interest charges wipe out your ability to pay down the debt.  It is best to not start carrying a balance in the first place.

2.  Always pay off high interest small debts quickly.  Ignore the minimum payment and especially ignore “skip a payment this month” months.

3.  Don’t use a credit card for emergencies.  Instead, keep a cash account to cover things like car repairs and medical emergencies.

This is the third post in a series on improving your financial literacy.  To find the while series, select “Financial Literacy” in “Posts by Category” on the right sidebar.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI
         

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Why is Compound Interest So Important to Your Finances


Today we go into the subject of compound interest, which can be your best friend when you’re saving and investing, but your worst enemy when you’re paying off loans and credit card balances.  If you understand how compound interest works, it will change your behavior since you’ll realize the potential gains you’re giving up and also realize how much money you’re paying out in interest when you keep balances.
Compound interest is the secret to becoming wealthy within your lifetime.  It is the reason that anyone with a middle class income who, starting in their early twenties, is willing to sacrifice a couple hundred dollars a month to save and invest, can be a multi-millionaire before retirement.  In fact, many people can become financially independent in their mid to late forties if they invest regularly due to the effects of compound interest.  The secret is starting early, since compound interest works better and better the longer you use it.

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If you are a teenager with a job and you talk to me, I’ll probably tell you to gather up $1000 of your earnings and open an Individual Retirement Account (IRA) with Vanguard, investing in one of their target date funds.  Most teenagers I tell this to get that glazed-over look in their eyes until I tell them that if they do so, they’ll have $500,000 at retirement for each $1,000 they contribute.  At that point they get far more interested.  The reason is compound interest.  How does this work?

Well, if you invest in the stock market, you can assume that you’ll get somewhere between 10-15% annualized returns over long periods of time like 15-40 years.  (Note, I make no such claim for periods of five to ten years.)  You can estimate how long it will take to double your money if you know the interest rate by dividing 72 by the interest rate/annualized rate-of-return.  For example, at 12% rate-of-return, your money will double every 6 years or so.  Taking your original $1,000 at age 16, and assuming you add nothing else from your job, this means you’ll have in your account:

Age       Balance

16            $1,000

22            $2,000

28            $4,000

34            $8,000

40            $16,000

46           $32,000

At this point you would probably be saying, “Yeah, $32,000 is nice, but you said I’d have $500,000.  I’ve waited 30 years, and all I have is $32,000.  What gives?”


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Here is where the magic of compounding comes in.  Watch how fast the balances grow as you go from age 46 to retirement age (70 years-old):

Age       Balance

46            $32,000

52            $64,000

58            $128,000

64            $256,000

70            $512,000

Notice that while you’re only making a few hundred or thousand every six years when you’re staring out, in the later years you’re making hundreds of thousands of dollars over those six-year periods.  In fact, you might easily see your account grow by $100,000 or more in a single year between the ages of 64 and 70!

The basic rules of compound interest when you’re investing are:

1. Invest early.  The more times your money compounds, the more you’ll have in the end.

2.  You get big growth at the end, slow growth at the start.  The more money you have, the more interest you’ll be generating.  You may only make a few dollars at the start per month, but then hundreds or thousands of dollars per month at the end.

3.  Wait as long as you can to withdraw money.  Again, you’re making the most at the end, so the later you pull the money out, the more you’ll have.

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4.  The higher your rate-of-return or interest rate, the more money you’ll have (by a lot).  If you take the example of investing $1,000 in an IRA at age 16, but put the money in bonds at 6% instead of stocks at 12%, you’ll only have $32,000 at age 70 instead of more than $500,000.  Note that you don’t have half as much – you have less than a tenth as much.  This is because your money will only double every 12 years at 6% interest instead of every six years as it did at 12%.  Every time it doubles, you’ll have twice as much (obviously).  Double it once and you’ll have two times as much.  Double it three times and you’ll have eight times as much.  This is why you invest in stocks instead of putting the money in a savings account if you have many years to invest.

5.  The more often your money compounds, the more money you’ll make.  Interest is applied yearly, monthly, weekly, daily, or continuously.  The more often the interest rate is applied, the more you’ll make.  This is because the interest on your interest is generated each time the interest rate is applied.  If you have a choice between two investments at the same interest rate, but one compounds daily and the other monthly, pick the daily one.

I remember a dramatic example of this published in a Richie Rich comic book back in the 1980’s.  Richie Rich was asked for a donation.  He said that he would give one penny the first day, and then double his donation each day for the next 30 days.  A friend who saw this conversation scoffed, asking why his very wealthy friend was being so stingy with his money.  The last frame of the comic shows Richie Rich giving his last contribution – a sack of money containing $10,737,418.24!  That, is the power of compounding.

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Why does compound interest work so well?  The answer is that when you leave money in an account and allow it to compound, you start earning money not just from what you originally invested, but from the interest that builds up in your account as well.  In investing parlance, this is called reinvesting.  Reinvesting is very powerful since the amount that you get in interest or from capital gains from your stocks increases each year. Not only that, but the rate at which it increases grows every year.  The first year you get maybe a $10 return, the second you get at $12 return, the third you get a $15 return, the fourth you get a $ $20 return, and so on.  The interest on the interest from the interest from the interest from your original investment makes interest.  This means that the longer you wait, the bigger your income each year will be.

Compound interest is great when you’re saving and investing, but it works against you when you’re borrowing money.  That’s because then the interest that builds up in your account over the month or even over the day generates interest on itself.  This means that when you’re paying back a mortgage or student loan debt, you’ll end up paying back way more than you borrowed.  We’ll talk about this in the next post in this series.

 This is the second post in a series on improving your financial literacy.  To find the while series, select “Financial Literacy” in “Posts by Category” on the right sidebar.

Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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