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April 7, 2008, 3:05 pm
Key mathematical concepts and terms that can help get a handle on your personal finances.
While you don’t have to be a mathematical genius to manage your personal finances effectively, it certainly doesn’t hurt. You can’t really discuss money management without referring to the numbers to some degree. Fortunately, the simple additions and subtractions needed to pay the bills and balance your checkbook can be done with a calculator.
Still, if you really want to take your personal financial success to the next level, there are a few mathematical concepts that can be a big help. In the following synopsis, we've taken a few terms and defined them in a way you should find useful.
Annual Percentage Rate. This is the most important term you should know when it comes to your credit cards and other revolving debt. An annual percentage rate (or APR) is the percentage of what you owe that is charged to you as a finance fee. A rarely understood fact is that your credit card’s APR doesn’t accurately represent how much you actually pay if you don't pay it off right away. For example, let’s say you have an APR of 18 percent on a balance of $1,000. You might be led to believe that you are charged $180 (or 18 percent of your debt) per year.
In reality, that 18 percent is divided into 12 monthly interest rates, which comes to 1.5 percent, and applied monthly. This interset then compounds each month, which means you are charged interest on the earlier interest fee. So the actual finance charge on the original amount comes to about 19.6 percent after 12 months.
Compound Interest. Compound interest can also work in your favor. For example, suppose you have $1,000 in a savings account paying 5 percent annual interest, compounded quarterly. After one quarter, a fourth of the annual interest, or 1.25 percent, would be applied to your balance, giving you $1,012.50. Another quarter goes by, and this time, that 1.25 percent is applied to the new balance, leaving you with $1,025.16. By the end of the year, your balance is $1,050.95. Over the long haul, thanks to compound interest, your money grows at a faster and faster rate. And, of course, making contributions to the savings every month, makes it grow even faster.
Rule of 72. This is a formula commonly used by lenders and investors to determine how long it will take to double an initial investment. The basic formula is to divide 72 by the interest rate paid on an investment, such as a savings account or mutual fund. The number you get is the number of years it takes to double your money. For example, if you have a $1,000 in a fixed-interest bond fund that pays 8 percent, according to the rule of 72, it will take nine years for that investment to reach $2,000 (72 divided by 8 percent equals nine years).
Debt to Income Ratio. This formula is used by lenders to help determine how much of a credit risk you are. The higher your debt to income ratio is, the harder it is to get approved for a loan. To figure your debt/income ratio, add all your monthly payments on non-mortgage debts, including credit cards, auto loans and consumer loans. Then divide that total by your monthly take-home pay. If the result is less than 15 percent, you’re in good shape. If it’s over 20 percent, you need to consider restructuring your finances.
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