economicmultipliers_16

Economic Multipliers (16)

Do you know what these are?

They help CREATE wealth in systems.

A nation that understands some basic things about math has an easier time creating economic multipliers.

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When you finish reading this text, you will know how lending institutions calculate monthly payments for loans: They use a number called the 'amortization factor.'

Since this text is about a mathematical concept, please don’t panic if your brain normally shuts down at the site of equations. Know that you will neither have to derive any equations nor figure out how to program them into your calculator or computer (unless you want to).

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The individual who originally came up with this equation was one of many mathematical geniuses from the past to whom we owe a debt of gratitude:

The amortization factor (A.F.) = i / ((1 – (1 / (1 + i) **n))

where the monthly (or quarterly or yearly, etc.) payment for a debt equals the A.F. (the amortization factor) times the initial loan amount.

<¤> i = I (annual interest rate ... as a decimal) / # months per year of payments (normally 12)

... for a 6 percent interest rate, the decimal equivalent is 0.06 ... and ... 0.06/12 = 0.005 ...

<¤> n = total number of payments (generally # of years times 12)

To see this looking more ‘mathematical,’ open this: (OPEN).

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Amortization means to liquidate (get rid of) a debt by making regular payments.

A factor is a number that, once calculated for a certain set of conditions (i.e. the length of the loan, the number of payments and the interest rate), stays constant. For that set of conditions, you can use it to assess the impact on different loan amounts.

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As an example, if you took out a 6 percent interest loan for 4 years for $5000 on a used car, your monthly payment (calculated by the lender) would be:

$5000 x 0.005 / ((1 – (1 / (1 + 0.005)**48)) = $5000 x 0.023485 = $117.43

For an $8000 loan: $8000 x 0.023485 = $187.88

If there are any loan origination fees or other fees, those might be added onto the loan or they might be charged upfront: YOU should know ahead of time what any monthly payments should be, whether there are any extra fees and if there are, how they will affect any payments you might have to make. Likewise, even though this is a ‘calculated’ value, the monthly payment a lender calculates might be a penny more (all those decimal places that you don’t see that ‘pay off’ the loan).

Financial calculators are everywhere: handheld calculators with financial functions, Internet ‘mortgage’ calculators, accounting package spreadsheets, etc. I have no intention of replacing any of them but included an ‘album’ with ‘test numbers’ so if you’re using one, you can check to make sure you’re doing it right (i.e. plug in the numbers and make sure you come out with the correct answers). (OPEN)

Of course, there are some common sense ‘rules of thumb':

• • The payment amount times the number of payments should always exceed the loan amount: If interest rates are low and the loan term short, you’ll pay back a bit more than what you borrowed. (OPEN)

  • If interest rates are high and/or the number of years long, the amount you’ll pay back on the loan can greatly exceed the loan amount. (OPEN)

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If people who lent money didn’t want to make money doing so, interest rates would be zero percent (0.0 %). And, if interest rates were zero percent, all of us would live in a much ‘poorer’ world. Economic multipliers (in the monetary sense where people expect money to ‘earn’ money) have been creating wealth for centuries. (Have you noticed that I’ve still never fully defined the ‘formal’ concept? – mainly because I’m broadening it so you can see how you can think about the money and resources around you as ‘bases of wealth' which have the capacity to create wealth).

The reason you should want to understand the basic concept of amortization is because everything you buy is some sort of investment whether it’s a home, a car, enjoyment, education, food, health, etc. To have economic multipliers, ‘resources’ must create more ‘resources.'

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Now optimally, whenever you buy anything, you want the ‘value’ of what you have to always exceed the loan amount just in case you need or want to sell the item: this includes things you buy on credit if you don’t plan on completely paying for the items right away.

One of the reasons depreciation in housing markets is so damaging to people who might need to move is because if the value of the mortgage exceeds the value of the property, those individuals are destined to ‘lose wealth.'

People who don’t need to move might FEEL poorer but as long as they can pay their mortgage and property taxes and keep the property maintained, they will ultimately pay off their mortgage and be left with a ‘valuable asset.’ Effectively, the loss of equity in the housing market (for them) simply meant that they paid a higher ‘real’ interest rate because their payments covered something that had a ‘lesser’ value. Over time, they have a ‘chance’ that the market will recover.

All purchases that involve borrowing money CAN make things more expensive but LOTS of things make LOTS of sense: some examples are homes and cars which have standard markets, business borrowing where the money borrowed is used to buy and produce things which can be sold, educational loans which prepare individuals for the workforce, etc.

When you think about borrowing (via a credit card or ANY other kind of loan), you should think: This will take time to repay: What longterm value will help repay it? How will this ‘purchase’ (what I’m using the money for) increase my longterm base of wealth?

If you know the answers to those questions and you’ve made sure that you know how to calculate the ‘true’ cost of any loan (via the payments you’ll make to repay it), there’s a very good possibility that you will always use credit wisely.

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P.S. I looked at a house 20+ years ago which seemed perfect for ‘the me’ at that point in my life. Even though I was between jobs (unemployed) at that point in time, the real estate agent was SURE that she could arrange a loan. I calculated (using amortization tables) that if my next job paid the same as my prior one, I would have enough money to make the mortgage, household maintenance and utility payments and property tax payments but basically have no money left to ‘live life.'

I don’t know if the real estate agent was a personal friend of the sellers. I do know that if she had arranged the loan, she would have gotten her commission on the sale (over $3000 from me). If I had had difficulty finding a job in that market (and I did take a job in another state), I would have had a house to sell, out-of-control house payments to make in the shortterm and probably would have lost any equity I had invested in the property.

My point merely is: If someone wants to ‘help’ you into a loan, think about how they might be ‘helping’ themselves at the same time.

You should WANT people to make money who help you make good investments and choices but ultimately it’s up to you to make sure that you’re getting good advice.

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P.S. P.S. Years ago, I wrote the above amortization formula in a book I had purchased entitled: Monthly Loan & Mortgage Payment Tables (W.T. Rogers Company, Madison, WI, 1985). In 1985, people couldn’t imagine that anyone would lend out money at less than 8 percent (the tables in the book covered 8 to 20 percent interest loans). A year later, the auto manufacturers were offering car loans for less than 5 percent (one even offered 2 year loans at zero percent).

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P.S. P.S. P.S. I noted that ‘fire sales’ of properties tend to make people poorer and that is true of any asset that people own. Of course, the ‘buyers’ hope that they can capitalize on (profit from) the fire sales by buying cheap and waiting for the market to recover. The problem with this philosophy for things like homes and business properties is that people tend to take better care of property if they own AND occupy it.

‘Profiteers’ in housing markets don’t normally live in their investments and as a result, neighborhoods can deteriorate very rapidly. When neighborhoods deteriorate, communities get poorer. And, when communities get poorer, effectively the whole nation gets poorer.

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P.S. P.S. P.S. P.S. When I ‘programmed’ the amortization factor into an Excel spreadsheet, this is how I did it: =(B3/(100*B5))/(1-(1/((1+B3/(100*B5))^(B5*B4)))) … B3 referenced the annual interest rate as a straight percentage (no decimal – i.e. you'd enter 6.5 in the B3 cell for 6.5 percent annual interest instead of 0.065 ... division by 100 is in the Excel formula ... and, when you enter the formula in, click on the checkmark to the left of the entry box when you're done) … B5 referenced the number of payments per year … B4 referenced the number of years of the loan. There probably are easier ways to get to this number (probably even a pre-programmed function that calculates it) but this is how I calculated it. Those mathematical geniuses of old left us with a LOT of great ‘stuff’ … it’s just a matter of learning how to use it well.

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P.S. P.S. P.S. P.S. P.S. And, along the lines of learning how to use things (like knowledge) well: Flooding has become a problem in many communities throughout the world. Protecting the value of already existing assets preserves wealth. I’ll just cover one item: car engines.

Some very smart mechanics have a radio show and newspaper column: the CarTalk guys (www.cartalk.com). If you visit their site and type in ‘flooding,’ you’ll get some really good advice.

If your car ‘takes in’ some water while driving and stalls, think about things like: don’t start it, change the oil and transmission fluid immediately (oil maybe more than once), pull the plugs and check for water (and then probably put some oil in through the ports), etc. You – or your mechanic – need to think about whether water could have gotten in through any air intake system … and a rapid response is important. If a car has sat in water for an extended period of time and/or has any sophisticated electronics, unfortunately you’ll have extra things to think about.

Our neighborhood recently had high water (luckily no major flooding). A young neighbor stalled his car but fortunately his older relatives knew exactly what to do. It wouldn’t surprise me if, after the fact, they casually mentioned that parking the car four houses down in a dry parking spot would have made more sense (and taken them a lot less time and energy) than driving through the water. (Imagine trying to deal with the problem while expecting even more rain.)

This young man is very smart … I’ll bet he and his friends have already prepared high water ‘smart driving’ plans. If this could be an issue for you in your area, have you?