• Lecture 17 Annual Payment.XLS• Lecture 17 Monthly Payment.XLS• Lecture 17 Equity Growth.XLS• Lecture 17 Retirement

Calculator.XLS

• Sources of information– Dave Ramsey -- The Total Money

Makeover: A Proven Plan for Financial Fitness. It is available at most book stores and on line

– Personal experience and observing successful people

Materials for Lecture 17

• This lecture is not about business management

• It is about personal money management

• I ask again: “Do you want to spend your life managing debt or wealth?”

• People work for 2 reasons:– Cover costs for necessities– Increase net worth (so we can retire)

• To achieve this goal we must manage wealth

Do You Want to Manage Debt or Wealth?

• First Step is to become debt free• Second step is to build wealth• Reasons to build wealth

– Retirement– Security– Have Fun

• Money is Not the root of all evil • Desire of money is the root of all

evil

To Manage Wealth

• Cut Expenses so you live within your means and SAVE

• Stop using credit cards – pay cash or postpone purchases

• Buy used cars 1-2 years old, keep them a few years and trade again– After you have built wealth then you can

afford to buy new cars– NEVER lease a vehicle

• Think about it, you are paying for the car plus interest PLUS someone else’s profits

Steps to Becoming Debt Free

• Yes, before you start paying off debt build a cash reserve – your personal VAR fund

• Why a cash reserve? How much? Where do I invest it?– Cash reserve pay for an emergency: as

job loss Not to go on a vacation, go to a wedding, or …

– Cash reserve should be equal to 3 times your after-tax Monthly salary

– Invest it in a Money Market account, interest is low but MMs usually require a min check size of $250 so it discourages using it on little items

Build a Cash Reserve

• How do you build a cash reserve?• Sell something

– Garage sale– Extra vehicle– Move to cheaper house, etc.

• Get a part time job– Deliver papers before work– Deliver pizza after work– Start a business doing something other

people do not want to do for themselves• This is not permanent just to get a

reserve

How to Build a Cash Reserve

• Sort debts from low to high: D1, D2, .., Dn

• Pay the maximum extra you can on the smallest debt (D1) until it is paid off

• Use money you had been paying on D1 and add it to the payment on D2 until it is paid

• Continue this until all debts are paid off

• Euphoria from paying off a debt is great so get the feeling early by attacking the lowest debt (D1) first, then move to D2 …..

• Making double and triple payments

Develop a Plan to Pay Off Debts

• Do Not Get into Trouble with Credit Card Debt!

• Look how long it takes to pay off a credit card debt: here I tested 2 different interest rates

Do Not Get Back Into Debt

Inputs for the LoanCredit Card Minimum Annual Payment/Month 87

Debt Payment Interest Rate Interest Paid 4,7825,827 87 0.15 Approx Total Cost 10,614

Number of Months to Pay Off Loan Making Minimum Payments 122 Months

Results for the Loan

Inputs for the Loan

Credit Card Minimum Annual Payment/Month 87

Debt Payment Interest Rate Interest Paid 8,015

5,827 87 0.2 Approx Total Cost 13,659Number of Months to Pay Off Loan Making Minimum Payments NEVER

Results for the Loan

• Use Cash or Debit Cards• Can I ever use a Credit Card

again?– Yes if your job reimburses your travel

expenses– Have one separate card for ONLY

travel that will be reimbursed• Avoid all kinds of debt

– Save money to buy a car– Do not take vacations until can pay

cash– Stay off of cruise ships– Save money for a house

Do Not Get Back Into Debt

• The total cost of a $40,000 car • Financed 72 months =$46,382 to $49,101• Shorter the loan, the lower total cost

Years and Cost to Finance a Car

Amount No. of Months Annual Monthly Total Cost/Borrowed for Loan Life Interest Rate Payment Interst Total Cost Initial Cost

40,000 72 0.05 644 6,382 46,382 1.16040,000 60 0.05 755 5,291 45,291 1.13240,000 48 0.05 921 4,216 44,216 1.10540,000 36 0.05 1,199 3,158 43,158 1.07940,000 24 0.05 1,755 2,117 42,117 1.053

40,000 72 0.07 682 9,101 49,101 1.22840,000 60 0.07 792 7,523 47,523 1.18840,000 48 0.07 958 5,977 45,977 1.14940,000 36 0.07 1,235 4,463 44,463 1.11240,000 24 0.07 1,791 2,982 42,982 1.075

• Renting – Provides no income tax deductions

• But do you have sufficient income to itemize deductions? Probably not when starting out

– Does not build equity• Ownership

– Builds equity (very slowly)– Often get over extended with large

payments– Small income tax deductions on the

whole– Do not acquire debt to reduce income

taxes!– Save for a house; make a large down

payment

Housing: Buy or Rent

• Examine total cost of a $100,000 home

• Financing for 15 vs. 30 years is $77,076

Years and Cost to Finance a Home

Amount No. Year for Annual TotalBorrowed Loan Life Interest Rate Payment Interest Total Cost

100,000 5 0.07 24,389 21,945 121,945 100,000 10 0.07 14,238 42,378 142,378 100,000 15 0.07 10,979 64,692 164,692 100,000 20 0.07 9,439 88,786 188,786 100,000 25 0.07 8,581 114,526 214,526 100,000 30 0.07 8,059 141,759 241,759

Stochastic Equity Growth for a Home Loan

After 5 Years, how much equity do you have?

Depends on how long you financed

Will your job let you stay for 30 years?

Input for the Loan

Amount No. Year for Annual First Year ofBorrowed Loan Life Interest Rate the Loan

100,000 5 0.07 2011=SCENARIO(P25:P30)

Value Home GRKS for Appreciation in Value105,000 -0.1 0.03 0.07

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

-20,000 0 20,000 40,000 60,000 80,000 100,000 120,000 140,000

Prob

Net Worth CDFs for 6 Financing Periods

NW 5 Yr NW 10 Yr NW 15 Yr NW 20 Yr NW 25 Yr NW 30 Yr

• Do not change standard of living -- SAVE

• Save for what? – Retirement– Children’s educ – #529 College Savings

Plan• Where do you invest your savings?

– Low load mutual funds – lots to choose from• American Funds, ING, etc.

– Make sure you can move money among the Funds Family without a cost

– Get a broker, but do not let them make trades for you – can lead to account churning

Once You Are Debt Free, What’s Next?

Example of Mutual Funds

• When do I start? How much should I save? Is it to late? What about Social Security for your retirement?

• In the future, businesses will not provide retirement accounts

• You will be on your own to save through an IRA – Some businesses will provide

matching funds – Some will offer managed IRAs with

limited options

Retirement Savings

• Start saving the day you graduate• Save as much as you can but at

least save 15% of your gross salary annually

• Keep working and paying into Social Security so I can collect it after I retire– Do not depend on Social Security to

cover your retirement needs– Today estimate SS will pay me 19% of

my current take home pay; after paying for 48 years

Retirement Savings

• Social Security has no store of money

• Congress will be forced to act on these entitlements– Debt ceiling, sequestration, budget

reductions from Super Committee– All these add up to changes

• Probable changes– Extending retirement age– Means testing based on wealth or

income– Reduced payment rates

Social Security and Medicare/Medicaid

• Tax DEFERRED savings– Traditional IRA - $5,000/year per

person unless over 60 then save $6,000/year

– If you are in a company retirement plan can still use the maximum Traditional IRA

– If you are self employed you can have a • SEP IRA – 25% of business income up to

$50,000 tax deferred• KEOGH plan – 25% of self-employed

income up to $49,000 tax deferred

• Not tax deferred savings– You can save as MUCH as you want

IRS and Retirement Savings

• Variables to consider– Current age and amount you have saved– Current salary and expected raises– Age you want to retire– Consumption expenditures after you

retire– Annual rate of inflation pre & post

retirement– Returns you expect on savings until

retirement– Returns on savings after you retire– How long do you & spouse expect to live

• Which of these variables are stochastic?

Retirement Savings is a Risky Investment

• I made a Monte Carlo simulation model to calculate retirement savings

• With lots of stochastic & input variables

Retirement Calculator

Lecture 20 Retirement Calculator.xlsxJames W. Richardson © 2011

Current Calendar Year 2012Current Age Person to Retire Last -- No. 1 27 Current Age Person to Retire First -- No. 2 27 Retirement Age for last to Retire 65 Retirement Age for First to Retire 65

Consumption and Salaries In Current $sNo. 1 Salary Net of Retirement, Tax & Insur. 49,000 No. 2 Salary Net of Retirement, Tax & Insur. 50,000 Total Salary Net of Retirement Taxes & Insur. 99,000 Annual Current Living Expenses Ex retire, ins 75,000 Annual Living Expenses After Retirement 75,000

Annual Additions to Each Retirement Account Until RetirementNo. 1's Retirement Contribution/Year 7,350 No. 2's Retirement Contribution/Yeat 7,500 Additional Annual PlannedSavings - Age When Broke 84

(1,100)

(100)

900

1,900

2,900

3,900

4,900

Th

ou

san

ds

Age

Value of Retirement Account

Output: Annual Value of Cash Reserves

(14,000)

(12,000)

(10,000)

(8,000)

(6,000)

(4,000)

(2,000)

-

2,000

4,000

6,000

Th

ou

sa

nd

s

Fan Graph of Ending Cash Balances for Each Year After Retirement, Assuming Retire at Age 65 and Consume $75,000/Year in 2012$s

Average 5th Percentile 25th Percentile 75th Percentile 95th Percentile

Output: Probability of Positive Cash

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Pro

ba

bili

ty

Probability of Positive Cash Balance Each Year After Retirement, Assuming Retire at Age 65 and Consume $75,000/Year in 2012$s

• Enter your own values • Simulate using the KOV table starting

in row 177• What age do you have a zero wealth?• How much do you have to save to

give yourself a 95% chance of having wealth when you are 90 or 95 or even 100?

• Did you marry the right person ($’s)?• Remember divorce cuts your wealth in

half so it takes longer to save for retirement

Open the Retirement Calculator

• Linear programming – what ought to be• Probabilistic forecasting – capabilities of

forecasting with multiple regression, exponential smoothing, seasonal analysis, and time series analysis

• Monte Carlo simulation – what could be ….– Frame your problem in a systems framework– Model design and development– Parameter estimation for stochastic variables

and deterministic component of a forecast – Validate simulated variables– Univariate and MV distributions

• Apply these tools for business and personal decision making using stochastic efficiency

Summary of AGEC 622

• Improved Excel skills• Applied econometrics• Ability to organize & build a business

model• Make any business model a risk analysis

tool• Rank risky alternatives• Deterministic and probabilistic forecasting• Simetar

– Available as long as you are a fulltime student– After you graduate, buy it at www.simetar.com

• If you do not have Simetar, you can use @Risk=NORM() same as =RISKNORMAL() =UNIFORM() same as =RISKUNIFORM()

What can you take to the job?