In past columns, I have discussed the impact of inflation on your long-term financial planning. This is a brief refresher, as the topic is very important at this stage of your financial plan’s development.
Inflation is everyone’s largest financial obstacle. It is what causes the cost of goods and services to keep increasing year after year. Looked at another way, it is what causes the value of your money to shrink. The following graph assumes an inflation rate of 8 percent (the average inflation rate for the last 45 years) and shows the long-term effects of inflation. It follows the plight of an 18-year-old who starts out with $1 in his pocket.
By age 27, the $1 will have shrunk in value to 50 cents. What the 18-year-old could have bought for $1 will cost $2 by age 27. If you follow this path, by the time this person reaches 63 (around retirement age), the value of the original dollar will be just three cents, and it will cost $32 to buy what $1 bought back at age 18.
To counter the effects of inflation, your money must be earning a higher rate of interest than the rate of inflation.
If you put $10,000 in a savings account earning 1 percent, after one year, you would earn $100. Of course, you will have to pay taxes on your earnings. So if you are in the 28 percent tax bracket, that comes to $28.
However, you cannot stop your calculation there. You also need to factor in the effects of inflation. At 2.5 percent inflation, your money would lose $250 in buying power over the course of a year. In other words, one year after depositing your money in the bank, after interest, your $10,000 would be worth $$9,822! This illustration gets much worse if inflation and interest rates rise.
No wonder so many people find it hard to get ahead.
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Number verses value of dollars
The main problem with inflation is that most of us are taught to think in terms of the number of dollars we spend. We do not give enough thought to the value that those dollars represent.
If you have a 30-year mortgage, have you ever multiplied your monthly payment by 12 to figure out the annual cost of your home, and then multiplied that number by 30 to figure out the total cost of your home? If so, you were probably shocked to discover that your home will end up costing you about three times the purchase price. You may have even wished you could have paid cash for your home so you could avoid paying all that interest. That’s thinking in terms of number of dollars.
A new perspective
Try looking at your mortgage dollars this way: If inflation is running at 8 percent, we know that in nine years the value of your money will be half of what it is today. Therefore, while you will spend exactly the same number of dollars in nine years, the value of those dollars will be only one-half. In another nine years, you’ll be spending 25 cents on the dollar. And in another nine years, you’ll be spending 12.5 cents on the dollar.
If this still isn’t clear, here’s another way to look at it: When you first bought your home, it probably required a significant percentage of your monthly income to make the mortgage payment. But if you have lived in your home for any length of time, because your salary has grown while your monthly payment has remained constant, the mortgage now takes a much smaller percentage of your income.
To properly understand inflation and accomplish your financial goals, you must realize that money has a value corresponding to the year in which you spend it.
In last week’s column, I showed you how to establish your financial goals. Now let’s see how inflation affects costs. Let’s say you’d like to have enough money for a 20 percent down payment on a condominium near the ocean in five years. You look at what is available today and determine that today’s cost of the condominium you’d like to buy is $250,000. Twenty percent of that is $50,000.
Now refer to the chart below to calculate the impact of inflation on your current goals. Use whatever inflation rate you feel the asset class you want to buy will experience over the anticipated time. For example, if you select six percent, use the multiplier where the six percent and five year columns intersect. Multiply $50,000 by 1.34 and you get the answer of $67,000; that is what the down payment on your desired condo will cost in five years.
This chart will help you calculate the future cost of today’s financial goals, based on various rates of inflation and the number of years that you have to meet your goals. However, do not use this chart for your retirement or college fund goals. Separate charts and methods for calculating the costs of those goals will be provided in later columns.
In my next column, I will teach you how to put a price tag on your goals.
So let’s recap the procedure:
- Determine today’s cost of each of your goals;
- Determine how many years you have to meet your goals;
- Choose an inflation rate you feel is realistic for the time period between now and the date you’d like to accomplish your goal;
- Find the multiplier where your inflation rate meets your time period;
- Multiply today’s cost of your goal by the multiplier.
- The answer is the future cost of your goal.
You should use this procedure with each of your goals, except a college fund and retirement. Those goals will be covered later columns.