Einstein and Compound Interest.
Did Albert Einstein say that "compound interest is the greatest discovery in the world". Just Google "Einstein's quote on compound interest" and you will find several references and a reference to the rule of 72 .
Monthly Mortgage Payments.
Now what does this have to do with buying and selling homes? Most people do not pay cash for a home, even if they could afford to do so. A financial advisor might suggest that they diversify their porfolio and invest in more than one thing. If you borrow money from a bank or mortgage company then you can pay them back in monthly installments. But how much is the monthly payment, and how much can you afford to allocate for a new purchase.
I was recently talking with a client about this very question. Bill Bucks was interested in a property for a second home, and was taking a careful approach to investing. We had just seen a home that he liked very much, and he wondered how much the monthly payments would be. It turned out that he had asked his bank to get back to him that week with this kind of information, but no one had called for several days.
So I said to Bill. "Anyone can be an Einstein about monthly payments on a loan because there is one interest rate (6.0%) and loan period (30 years) for which the monthly payment (principal plus interest) is exactly $600.00 for each $100,000 of the loan. Let's do the calculation now. We can check with the experts later."
This means that if the loan was for $100,000, $200,000 or $300,000, then the monthly payment would be $600, $1200, or $1800. This is very handy knowledge indeed. You can do the calculation in your head or on the back of an invelope with a pen or pencil, and then you can make some preliminary feasibility decisions. When you get on-line with your computer at a mortgage web site such as, http://countrywide.dorado.com/marilynskjoldal/CalculatorsPayment then you can get exact monthly payments and you can talk a persona about financial matters in detail and get "pre-approved" or "pre-qualified for a loan.
The Rule of 72
The rule of 72 is the rule of thumb "par excellence" for calculating how long it will take to double the dollar value of your investment at a specified interest rate. Suppose that King Midas put $100,000 in a savings bank account that paid 6% compound interest a year. How long would it take to double his money? With lightning speed you get the answer by dividing 72 by 6 to get 12 years! Would Warren Buffet do this? Hardly, he invests in undervalued or undiscovered stocks with great growth potential, and this is why he is a renown billionaire today, and both he and Bill Gates can donate billions of dollars to a common charitable trust to help underdeveloped countries. You can be sure that they want the trust to be well managed so that the capital grows faster than inflation. Then a billion or so can be spent each year for worthy causes, without making a financial dent, but nevertheless making a very big difference in wiping out child diseases in poverty stricken countries. Maybe Einstein was right .. "compound interest is the greatest discovery in the world".
But what if you have to pay federal income tax on your earned interest each year? How long would it take to double your money? Well, 6% interest on a savings deposit of $100,000 is $6,000. Suppose you must pay $1,000 tax (1/6 of the earnings or 16 percent incremental tax bracket), then your effective earned interest is $5,000 or only 5%. This means it will take 72/5 = 14.4 years to double your money. And if you are in the 50% incremental tax bracket, then your effective interest rate is only 3% and it would take twice as long 24 years to double your money. Humm.... there must be a better way!
With a few sobering estimates like this, you realize that you need a financial advisor. First, if inflation itself were to run at 6% a year, then your bank savings would only be worth the original deposit of $100,000, and the purchasing power of these dollars has been cut in half. You would be no worse off by stuffing the money in a mattress. So interest paid must be more than inflation, and taxes on earning should be deferred by choosing suitable investments. These are the financial balls that the Federal Reserve chairman juggles: try to hold down inflation by the bitter medicine of higher interest rates. But these higher interest rates today are still VERY LOW by historical standards.
I remember when,.. or the good old days.
I keep hearing people say how cheap things were in the good old days. Again the rule of 72, makes you an Einstein in financial analysis. Joe bought his first home for $18,000 in 1962 (45 years ago). What would that be by todays standards? Suppose the underlying inflation rate was 4% during this 45 year period, then there is lots of time for "doubling' according to the rule of 72. Dividing 72 by 4 gives 18 years to double the value of a home one time. So there is time for doubling twice ($72,000) but less than three doublings ($144,000). 4% is a low underlying inflation rate. What about 6% inflation? One doubling takes 12 years (72 divided by 6 percent =12 years). And the 45 year period is almost 4 doublings (45 divided by 12 = 3.75). So the gem of a home that sold for $18,000 would have an adjusted price of almost $288,000. Guess what? The same homes in that neighborhood are selling now for over $300,000 in 2007! It's the same amount of inflation adjusted dollars.
You can use the rule of 72 for the price of gas at the pump today. Is $3.00 a gallon so high? If there was 6 % underlying inflation in the price of gas, then in 1962 the cost would have doubled almost 4 times or (2 x2 x2 x2 =16) or 19 cents a gallon! But gas sold for around 40 cents a gallon, then so believe it or not Americans are getting good value for their money. The price of a gallon of gas in Canada or Europe is much higher.
