Saturday, April 11, 2015

Teaching Our Kids About Interest and Inflation

The Rule-of-72

An author made a statement that stopped me cold.  He expressed amazement that the American people unquestioningly accepted a Federal Reserve target inflation rate of 2% when that meant our savings over our working lifetime would be cut in half.  When I heard this on the audio book, I said "Huh?" and stopped the audio to think this over.  When we are taught the Rule-of-72 for investments we are told that dividing 72 by an annual interest rate gives us the number of years for our investment to double.  I never thought about the using an inflation rate to figure out when our savings are cut in half.   But 72 divided by a 2% inflation rate means that in 36 years the money you buried in the back yard is worth half (buys half as much) of its worth when you buried it.  Thirty-six years is a working career.  This is what the author was talking about.


The chart above shows how your money grows or shrinks over the years.  You can see at a glance why it is important to have some investments that average 12% growth and why we are so much better off with a 1% inflation rate than a 2% inflation rate.  I had never thought about the Rule-of-72 applying to inflation.  Of course it applies, but we don't think about it because we are not taught to think about it.  I went and talked to an intelligent engineer from one of the best engineering colleges in America about the Rule-of-72 for interest and for inflation.  He had never heard of the Rule-of-72 and was surprised that such a useful concept was never taught to him in school.

The schools are overloaded with what they have to teach, so it is up to us parents to teach our kids about the Rule-of-72.  Money is sort of like sex:  our children need to hear first from us parents about these complicated topics, we need to put them on the right track, and we need to shepherd them so they stay on the right path.

Debt is Dangerous

With the Rule-of-72 we can show our children that if they borrow money for college and they do not pay off the loan, they can see when their debt doubles.  For example, borrowing $20,000 at 6% interest, the debt will double to $40,000 after 12 years.  Some frustrated students are refusing to pay back their student debt.  Google "students refusing to pay back student loans" and you will get articles like "A revolt is growing as more people refuse to pay back student loans" by Danielle Douglas-Gabriel, The Washington Post.  Not paying a debt is dangerous because the debt continues to grow.

Remember I wrote earlier about college loans:  College Loans   Saturday, December 29, 2012

Interest Rates

You might have thought I was joking about burying money in the back yard, but putting money in the bank is not much different than burying it in the back yard.  My bank pays a 0.1% interest rate on savings, meaning it will take 720 years for my money to double.  I had pulled my money from a bank that paid a 0.01% interest rate that would take 7,200 years to double.  Wow!  7200 years is longer than all of recorded human history.


The interest paid by banks on savings is paced by the Federal Funds Rate, set by the Federal Reserve.  See the chart above.  This low interest rate is destroying the savings of average Americans.  This low interest rate also means our pension funds are dying for lack of safe investments, and some of us who have pensions will see them shrink or disappear.  Why does the Federal Reserve do something what hurts Americans?  Forget what they say, look at what happens.  The very pinnacle of America's wealthy class borrows money from the U.S. Government for free and then invests it in Asia to get large returns.  This is the true source of income inequality, the massive transfer of wealth from the average American saver to the very richest people in America.  Look at the chart above and remember how you used to get 3% on savings and 4% or 5% on CDs (certificates of deposit).  We need to get back to having at least a 2% or 3% interest on our savings, which means we need a Federal Funds rate above 2% or 3%. 

If we fail to teach our children about  money, then they will be hurt financially by what they do not understand.

Robert

P.S.
Too much is said of the "top 1%."  There are layers of wealth.  Think of Dallas (the city, not the metroplex) with a population of 1 million.  The top 1% would be 10,000 people.  I don't think we have that many millionaires in the city.  So the top 1% is the upper middle class/low echelon wealthy.  The top 1% of the top 1% would number 100 people.  I don't think we have a 100 billionaires in the city of Dallas.  One hundred millionaires maybe, but not 100 billionaires.  I would guess 10 billionaires in a city of 1 million. There might be 1.2 million people in Dallas, so this would be 12 billionaires.  We can google for this to find the real number and move beyond estimation.  This list shows 16 billionaires in Dallas, but only 1 billionaire in Dallas worth 10 billion.  Our estimates are fair approximations.  So here are the layers of wealth:
Top 1% = the upper middle class, low echelon wealthy
Top 1% of the top 1% = the millionaires
Top 10% of the top 1% of the top 1% = the billionaires
Top 1% of the top 1% of the top 1% = the wealthier billionaires
Wealth is far more concentrated than people realize.  Just 80 people own half of all the wealth in the world.  I am not passing judgment. I am simply saying that when I refer to the very pinnacle of America's wealthy class, I am talking about a small number of people.  And even this small group is not monolithic.

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