1. Building the pipeline will employ some number of people. The number is debatable. But what is not debatable is that there will be some new hires and new jobs are good.

2. Using oil that originates in Canada helps the US to wean itself of energy dependence on OPEC.

3. The US using the oil from the Canadian tar sands will help minimize the release of greenhouse gases into the atmosphere.

This appears to be a win-win-win situation. Consumers win in that they have a closer, more reliable source of energy. Construction works win in that they have a source for good jobs. The administration wins in that they can point to improved energy availability and a positive jobs story.

So then why is it that the pipeline has been at least delayed by the current administration? Joe Nocera discusses this in his New York Times column, “Poisoned Politics of Keystone XL”. He says the oil is “dirtier than the crude that pours forth from the Saudi Arabian desert — that is one of the main reasons environmentalists say they oppose Keystone”.

Unfortunately, the environmental groups are not looking at this issue the right way. The oil from the Canadian tar sand will be used. Period. If we here in the US don’t us it, then some other country, most likely China, will buy it. I don’t think this is in dispute.

Therefore, environmentalist need to ask themselves this question. Is it better for the oil to be refined and consumed in the US, or in a country such as China with less strict environmental regulations and controls? If we agree that the oil will be used somewhere, and if our goal is to minimize the release of greenhouse gases into the atmosphere, then I think environmentalists need to get on board and tell the President to reconsider his Keystone XL pipeline decision.

After all, the choice is not between the release of no greenhouse gases and some greenhouse gases, but rather it is between some greenhouse gases being released or more greenhouse gases being released. When viewed in that light, I think the decision is a simple one.

-Karl Thompson

In fact, the conversation about our debt has already started. In The New York Times on January 2nd, Paul Krugman writes in Nobody Understands Debt "the way our politicians and pundits think about debt is all wrong, and exaggerates the problem’s size". On the same day, the Libertarian Jew took another view.

The timing for these posts could not be better. We thought that it would be useful if we could help visitors comprehend the size of the national debt on personal terms. Thus, today, we have released:

The National Debt Calculator.

The calculator will calculate a monthly payment for your share of the national debt or your household’s share. Additionally, it will create a payment schedule for the number of years you desire.

And if you believe that the US national debt is becoming a problem, you can start sending the Federal Government a monthly payment to cover your share of the debt. Here are the details from the Treasury’s Bureau of the Public Debt website:

How do you make a contribution to reduce the debt?

A couple of final points.

• As I mentioned, the national debt as of January 1st, is about $15.1 trillion. That’s a big absolute number. The National Debt Calculator is able to create an amortization payment schedule for the entire amount. Just change the "Number of US Households" to "1". Monthly payments will be well into the 10s of billions of dollars and the running interest total will quickly exceed $1 trillion dollars. The calculator will be able to handle numbers this size.

And a point with respect to good governance:

• Whether or not you come down on the side of the federal debt being a problem, I think the way the Government and the media expresses its size, as a percentage of GDP, is wrong. Debt should be expressed as a percentage of income. Or in the case of the Government, as a percentage of tax receipts. The Government does not own the entire GDP. They do not control it. And they can not tax 100% of it. The Government does control allocation of tax receipts. It can use tax receipts to make debt payments as Congress and the President sees fit. It cannot use the GDP to make those payments. That would be like a person wanting to buy a car telling a loan officer, I work for a company that makes $100 million dollars a year. It simply doesn’t matter.
• Viewed in this light, the tax receipts for 2010 were $2.162 trillion. Our what percentage calculator shows that the debt is 699.0% of receipts.

You may draw your own conclusions.

Please feel free to comment about this post or the calculator. I am happy to answer questions pertaining to the calculator.

–Karl Thompson

"…total federal outlays are estimated to be $3.65 trillion in fiscal 2012, up slightly from $3.6 trillion in 2011."

At least now we have a paper reporting an amount for total Federal spending in FY2012. (Though it was reported in an editorial and not, as far as I can find, as part of the coverage of the news.)

Do you notice something though?

Here we have two of the country’s leading newspapers reporting on what should be a clear cut point of fact and yet their reporting contradicts each other.

For reference, from The New York Times

"This year’s spending bill, signed into law a few days ago, is roughly 10 percent lower than last year’s (my emphasis), cutting Pell grants, environmental programs and aid to desperate states. Low-income heating assistance was cut by 25 percent."

So who’s right? Are we going to spend slightly more in 2012 or almost 10% less? In this case, I tend to think The Wall Street Journal might be correct on this. I come to this conclusion though only because The Journal is willing to report a total spending number.

Does any reader know the answer to this? If so, please tell us, and let us know your source. It could be interesting.

One final note. Notice how the two papers characterize spending cuts. You see what The Times wrote above. Here’s what The Journal says:

"What about killing programs? Well, only 28 programs out of the thousands of line-items contained in the omnibus budget were terminated. The list includes mostly minor programs such as $12.5 million spent on something called “adolescent family life,” $1.2 million for civic education, and $1.4 million for economics education (not for members of Congress)."

"The one major domestic program of more than $100 million that got the axe was the Energy Department loan guarantee program for the likes of Solyndra. The total domestic savings from program terminations come to less than $0.5 billion. (Again, my emphasis.)"

With reporting like this, how are voters suppose to make informed decisions?

Many of us think we need a new government. Considering that the press is the forth branch of that government, it seems appropriate to include the press when we are talking about a government makeover.

–Karl Thompson

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A POSSIBLE CORRECTION: After rereading the New York Times editorial, I believe they were not referring to the entire 2012 budget as being almost 10% lower. They said the spending bill signed into law a few days ago which is referring to the 2012 omnibus spending bill. This is the $1 trillion dollar bill that President Obama signed on Friday, December 23rd. If this is the case, then the Wall Street Journal and the New York Times are not necessarily contradicting each other. For one part of the budget may decrease and overall spending may increase. Too bad we have to parse sentences this way.

Reference: The Hill — Obama signs $1 trillion spending bill

What then stirred me enough to take the time to write this post?

The answer is found in one little sentence:

"This year’s spending bill, signed into law a few days ago, is roughly 10 percent lower than last year’s…"

Really? 10% lower? That means the Federal Government will be spending about $300-$350 billion dollars less in 2012 then it spent in 2011.

How do we know this?

You can’t tell it from the reporting done by the New York Times, the Wall Street Journal or any other news outlet that I can determine. Not a single major news organization that I can find has reported what the total projected spending will be for the US Government in 2012. And we are, as of today, 1/4 of the way through the 2012 fiscal year (of course Congress didn’t fully fund the Government until just two or so weeks ago).

Even the website, National Priorities Project, which has for their tag line “Bringing the Federal Budget Home”, does not report what total spending is projected to be for 2012. Their December 23 post, "Budget Matters", only reports that Congress had passed a budget for fiscal year 2012 by passing an omnibus spending package. Not a word is said about what total spending will be in FY2012.

OK, this may all be true, but what’s the big deal?

I’ll tell you. In the US, we are coming into what could be a watershed election year. The country is pretty well polarized between those that think the budget should be slashed to avoid becoming another Greece and those that think the budget should be increased to reduce unemployment.

In a free and democratic society, it is the job of the press to keep the citizens informed. As Republicans start to head to the polls during their primary season, it is even more important that the electorate knows about budget issues. How much we are spending is the most basic of all issues.

So, I ask you, is there any member of the press that can tell us, what we will spend in 2012? Is there any news organization that can tell us this important detail?

Before we can decide if we should spend more or if we should spend less, we should at least know what we are already committed to spend. (Even families before adjusting spending will frequently review their family budget.)

Until the Press can tell us this, it just isn’t doing its job.

Agree? Disagree? Let’s hear from you. Comments are now open.

–Karl Thompson

A Note: Yes, I know, total FY2012 spending isn’t even available on the Congressional Budget Office website as of this writing. So you may wonder how the press is going to come up with a total number? They should fire up their spreadsheets. Plug in the numbers from the 3 appropriation bills passed by Congress in November and the numbers from the December omnibus bill. This may not be totally accurate, but it’s better than just reporting on the amount covered by the December omnibus deal. What if they say they don’t have the resources for this undertaking? Then team up. The printed press and network broadcasters frequently team up to sponsor useless polls. They can channel some of those resources toward this endeavor.

And no, the New York Times reporting on the total Obama budget proposal back on February 14, 2011 doesn’t cut it either. This is the budget, as near as I can tell, that 100% of the Senators voted down earlier this year — not the budget that we are operating under.

There is a follow-up to this post. See Actually The Wall Street Journal Comes Through

According to the Mortgage Bankers Association of America (as reported by HousingWire), mortgage originations should total about $1.1 trillion for 2011, for one-to-four family homes in the United States. In addition, the United States Bureau of Transportation Statistics reports that there were 7.53 million new passenger automobiles sold in 2010, for a total retail sales value of $311 billion. If as in years past, approximately 70% of these new car purchases were financed, total new debt for new passenger car purchases would be approximately $240 billion. With the total value of new debt in these two categories exceeding $1.3 trillion for 2010, and assuming an average interest rate of only 6%, debtors will pay over $78 billion in annual interest carrying charges alone for just their single-year new purchases of homes and automobiles. The enormity of these amounts leads to a simple question:

Is it possible for borrowers to reduce their debt service costs? And if so, how?

The answer to the first question is certainly “yes.” The answer to the second question is…”that depends.” Since there are a number of techniques that can be used to reduce loan carrying costs, an individual needs to consider which method(s) is(are) best for him or her. This White Paper will discuss three self-help approaches that can be used to reduce the cost of almost any loan 1) simply, 2) without the borrower’s incurring any special ‘setup’ fees, and 3) without the need to consult a financial advisor or seek an advanced degree. The three methods are the accelerated payment (or extra principal payment) method, the initial short period method, and the fixed principal payment method. (Other techniques that can often be used will be discussed in a subsequent paper; they include the accelerated biweekly payment method and prepaying the next period’s principal.) The first of our current methods is widely known (although not necessarily well-understood) and can be implemented at any time during the course of paying off a loan. The latter two techniques can only be initiated during the loan application process, or shortly after origination (and, in either case, before the first payment is made).

Accelerated Payment Method

The first cost reduction technique is the “accelerated payment” method. Our first example may seem trivial to some, but it clearly illustrates how making a small extra principal payment, along with the regular payment, can reduce the consumer’s cost of carrying a debt. For illustration purposes, assume that a car is financed for $13,000.00, payable over 48 months, at 11% interest. A loan calculation shows that a monthly payment of $335.99 is needed to amortize completely this loan. Total interest paid over the 48 months will come to $3,127.60. Now assume that, once the borrower has recovered from the initial costs of making the purchase (insurance, down-payment, title, etc.), he or she can set aside an extra $50.00 a month toward repayment of the car loan. After the 6th payment, the consumer sends the lender an extra $50.00 a month, with instructions that the funds be applied to reduction of the principal. This extra monthly payment of $50.00 is then continued until the loan is paid off. Thus, for the first extra $50.00 principal payment, the borrower saves the interest that would have been owed on the $50.00 for the next 42 periods (approximately $19.25 for the single $50.00 payment over the remaining 3.5 years). Each subsequent extra payment saves the interest that would have been due on that amount for each of the remaining periods.

The cumulative effect of these modest extra payments can be significant. In this particular example, the savings add up to $384.19. While this may not seem like much (then again, neither is $50.00, but hey, it’s your money), it represents a savings of slightly more than 12% of the cost of the loan. What’s more, the loan is paid off over six months earlier than would otherwise be the case. The next example is far more dramatic.

Our next illustration assumes a $250,000.00 mortgage, taken out for 30 years, at 6.0%, with monthly payments of $1,498.88. Alas, total interest alone paid over the 360 months will typically come to $289,593! What would be the savings if an extra $250.00 were applied to principal each month, starting in say, the 13th month? In gross terms (i.e., before taxes), the interest savings will equal about $92,393, and instead of the loan being paid off with the 360th payment, it will be paid off after the 257th payment (that is, after 21.4 years instead of the standard 30 years). Thus, the mortgage is shortened by nearly 9 years.

What can be learned from these two examples? Firstly, that even a small increase in the monthly payment can save the consumer a significant percentage of the cost of carrying a loan. Secondly, that the longer the term of the loan and the earlier the extra payment starts, the greater the savings for the borrower. In the first example, the extra payment equals about 15% of the regular payment and commences after 12% of the payments have been made. As indicated above, the result is that the borrower saves about 12% of the cost of carrying the loan. In the second illustration, the extra payment is just about 16.6% of the regular payment, but commences when only about 3% of the payments have been made, resulting in savings that exceed 30% of the potential loan costs. Note also that, if the interest rate on the mortgage were equal to that of the car loan, the savings would be even greater. Therefore, we can also conclude that the higher the rate of interest, the greater the achievable savings from prepayment.

Short Initial Period Method

The next cost reduction technique we will examine is the “short initial period” method, an approach that many people can put to work almost painlessly. As the name suggests, this option is available to borrowers at or near the origination date of the loan. Consider, for a moment, the payment schedule of a typical consumer loan. Many such loans are set up with a monthly payment due on the first of each month. The borrower, however, almost never receives the proceeds (funds being borrowed) on the day of the month corresponding to the payment due date. For example, if the loan closes or the funds are advanced to the borrower on April 10th, it is said that the origination date is April 10th. The lender will most likely state that the first payment is due on June 1st. In cases like this, the loan has what is referred to as an “initial long period,” i.e., the first period is longer than the regular payment period. (In this case, the regular period is one month.) Don’t worry though, the lender isn’t granting the borrower use of the money without collecting interest! Assume, though, that the borrower has the first payment already set aside. After all, few mortgage lenders will even make a loan unless they know that the first couple of payments are available in a bank account. Therefore, what would be the effect on the cost of the loan if the first payment were made on May 1st instead of June 1st?

Surprisingly, the savings are very significant. Citing the same mortgage illustration that we used above ($150,000.00 mortgage, for 30 years, at 8.5%, with an origination date of April 10th of any year), if the first payment is made on June 1st, which is when most lenders will ask for it, the total interest paid on the loan will be $265,957.27. If, however, the first payment is made on May 1st instead, the total interest cost drops to $261,231.93. The savings exceed $4,700.00, simply because the borrower starts to pay back the loan one month early!

Now, let’s take this illustration one step farther. Suppose the borrower makes the first payment on April 11th. What do you suppose the savings will be? If moving the first payment date up by thirty days saves a little more than $4,700.00, then moving it up another 20 days or so should save, maybe, the better part of another $4,000.00, right? Wrong! If the first payment date is advanced to April 11th, the total interest paid over the term of the loan is reduced to $252,714.43, for a savings of over $13,200.00 compared to the typical first payment cycle, and over $8,500.00 compared even to a May 1st payment date! Granted, in percentage terms, this doesn’t save the consumer all that much: ‘only’ about 5% of the cost of the loan. But 5% of a big number is still a big number! Many people will feel that, in absolute terms, saving over $13,000.00 by simply moving the payments ahead by a month-and-a-half or so is not only worth doing, but tantamount to ‘money-in-the-bank.’ This is especially true if the modest amount required to initiate the tight first payment cycle is readily available or can somehow be cobbled together. The reader should note that achieving these savings does not require a restructuring of the loan. Nor does it require the borrower to subscribe to a special ‘cost reduction plan’ that some lending institutions offer. Also, it is not necessary to enlist the aid of an accountant or financial planner. In other words, the consumer does not have to go to much trouble, or pay for any services, in order to save real cash.

[Note on Payment-in-Advance for the Advanced Reader]

Some readers may be wondering why this last illustration didn’t suggest that the first payment be made on the origination date instead of one day after the origination date. It certainly could have been made then. Employing this calculation, however, tends to produce a result that appears quirky and counter-intuitive. At first glance, the savings will probably seem to be less than the savings made by starting the payments on April 11th. How can this be? You might say that this is due to an idiosyncrasy in the way most loan calculation routines work.

Actually, what is happening is very simple. Almost all loans are set up using a method called “payment-in-arrears.” This simply means that a lender lends a borrower some money and then, at some point in the future, the borrower starts to make payments to reduce the outstanding principal balance. The reason that the standard method is known as payment-in-arrears is because the borrower starts to make payments after he or she has had use of the money. (It does not mean that the borrower is in arrears or late with respect to the loan’s payment schedule, an unfavorable status known, of course, as “delinquency.”) In contrast, when the first payment is made on the origination date of the loan, the borrower has yet to have use of the loan proceeds when a payment is made. This concept is known as “payment-in-advance.” (Incidentally, leases typically use the payment-in-advance calculation method, and this is one of the ways lessors can achieve an apparently ‘low’ monthly payment amount; on closer examination, however, it is the lessee who is supporting the low monthly payment!)

A loan calculation program should recognize a loan that is based upon the payment-in-advance method when the origination date equals the first payment date. It will then calculate the payment using this different method, which is why the savings will appear to be less than the savings made by starting the payments one day after the loan origination date.

The reader should also note that, in the above mortgage illustration, if the loan is paid-in-advance, the payment drops from $1,153.37 to $1,145.26. This happens simply because the lower number is the payment amount required to amortize the principal over the entire term using the payment-in-advance method. When a loan calculation program sees that the first payment is one day after the origination date, it assumes a loan-in-arrears, which it is, and that the first period, while short, is indeed a full period. Thus, the payment amount is not adjusted but, because the first period is so short, most of the first payment is applied toward principal and the loan is accelerated.

Our payment-in-advance model goes to show just how much difference an $8.11 swing in the monthly payment amount can add up to over 30 years. In fact, the payment-in-advance method does save the borrower about $3,000.00 over the traditional payment-in-arrears loan when the first payment period is a full period or longer. Therefore, when invoked as an alternative to a traditional loan payment schedule, payment-in-advance can also be considered an actionable acceleration technique. Additionally, it has the benefit of reducing the periodic payment slightly. (If you wanted to see what the interest-cost reduction effect would be if a payment-in-advance loan were liquidated using the same payment amount as if paid in arrears, you would use an advanced loan calculation program that allows the user to override the calculated payment amount.)

Fixed Principal Payment Technique

The third and final loan acceleration technique covered in this presentation may require the borrower to shop around, or negotiate a little, in order to get it set up. Up until this point, we have only discussed loans that have level periodic payments, i.e., payment amounts constant from period-to-period (save, perhaps, an odd final payment). When a level payment amount is used, the interest due is calculated, then deducted from the payment. If there is anything ‘left over,’ the remainder of the payment is applied toward principal. As each payment is made, the amount of interest due decreases and the amount applied toward reduction of the loan’s principal increases.

Our technique, called the “fixed principal amortization” method, is characterized by a level principal payment (as opposed to the standard, level periodic payment, made up of both principal and interest), with the interest for each period added to the principal payment. The formula used to calculate a fixed principal payment mortgage is different from the formula used to calculate a level periodic payment mortgage. Using the mortgage example that we have employed above, the principal amount is divided by the number of payments (here, 360). In doing so, we find that 1/360th of the $150,000.00 principal amount is $416.67. Thus, $416.67 becomes the base for the payment. The interest for each period is added to this base amount to calculate the entire payment amount. (Remember that, for level payment loans, the interest is deducted from the payment.) This math results in a periodic payment that is not level because, as the principal is reduced for each period by $416.67, the amount of interest due declines, so less and less interest is added to the $416.67 base payment over the term of the mortgage.

The reader should note that, with a fixed principal payment loan, the payment is initially somewhat higher than for the more traditional level periodic payment loan, in this case by about $321.00, or 28%, at the first month. In fact, it is not until the borrower has made payments for a little more than 10 years that the payment amount finally drops to that of the traditional mortgage. This is because the fixed principal payment loan’s higher payments have reduced the mortgage’s balance by nearly $33,000.00, or 25%, more than have the 120 level payments on the traditional mortgage. Once the 10-year mark is reached, however, the payments quickly decline. By the end of the loan, the monthly payment is well below $500.00, or less than half of the $1,153.37 regular payment under a traditional mortgage payment schedule. Understandably, handling a higher-than-required monthly payment in the early years is often difficult for a first-time home-buyer. As a result, the fixed principal payment technique may be best initiated by a more seasoned mortgagor, for instance one who is ‘rolling over’ the proceeds of an appreciated home and can comfortably live with higher payments for the first few years. For such a veteran home-buyer, even these new, fixed principal monthly payments can be lower than the level periodic payments on his or her previous home. The best part is that this loan acceleration technique has a great payback. The total interest saved is almost $74,000.00, or nearly 30%, of the financing cost of the loan!

From Just Whose Pockets Will Your Savings Come?

Most lending agreements allow prepayment without penalty, especially after the first year. A lending institution will tend to sell most mortgages, and often, even unsecured debt, in the secondary market. This practice allows the loan’s originator to turn over its capital, thus freeing up funds with which to underwrite new loans; as part of this business approach, the lender may retain the loan’s lucrative servicing functions.

When a borrower redeems a mortgage early, whether by one day or a number of years–or saves carrying costs by any of the other methods we have addressed in this report–the consumer’s savings are likely to come from the bulging pockets of passive investors who have acquired an interest in a mortgage or loan portfolio. In a declining interest rate climate, early loan redemptions will have the effect of lowering the average yield on investors’ portfolios. In a market of rising rates, investors will gladly reinvest their portfolio proceeds in higher-yielding securities. But no matter what the interest rate environment, rest assured that the original lender, and any subsequent investors, have earned a fair return on the borrower’s loan for the period it remained outstanding.

While these debt service cost reduction techniques are not for everyone, borrowers should be aware of different strategies that they can employ–even insist upon–to reduce their costs. Many banks and finance companies, and mortgage banks and brokers, will accommodate custom loan packaging requests if asked, but will not volunteer them simply because they represent ‘exceptions’ to the path of least resistance. Clearly, lenders wish to sell their most profitable, lowest overhead products. Also, many borrowers, especially first-time home-buyers, tend to be impatient, insecure, or reluctant to push for the terms they really need. But if consumers can manage the uncertainty and stress of major purchases, and reduce their effective carrying charges by just a few percentage points on every loan, there will be millions of well-rested people, and billions of dollars available, for productive uses in our economy.

Notes:

a) This paper was originally written and published by Karl Thompson. The author is grateful for the editing work done by Mr. Marlow.

b) This paper may be freely published provided that the above copyright notice is attached, along with the appropriate byline. Portions may be quoted for illustration purposes.

MAKING MONEY: The most popular piece I’ve published in 40 years of writing these Letters was entitled, “Rich Man, Poor Man.” I have had dozens of requests to run this piece again or for permission to reprint it for various business organizations.

Making money entails a lot more than predicting which way the stock or bond markets are heading or trying to figure which stock or fund will double over the next few years. For the great majority of investors, making money requires a plan, self-discipline and desire. I say, “for the great majority of people” because if you’re a Steven Spielberg or a Bill Gates you don’t have to know about the Dow or the markets or about yields or price/earnings ratios. You’re a phenomenon in your own field, and you’re going to make big money as a by-product of your talent and ability. But this kind of genius is rare.

For the average investor, you and me, we’re not geniuses so we have to have a financial plan. In view of this, I offer below a few items that we must be aware of if we are serious about making money.

Rule 1: Compounding:

One of the most important lessons for living in the modern world is that to survive you’ve got to have money. But to live (survive) happily, you must have love, health (mental and physical), freedom, intellectual stimulation — and money. When I taught my kids about money, the first thing I taught them was the use of the “money bible.” What’s the money bible? Simple, it’s a volume of the compounding interest tables.

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need a knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time.

But there are two catches in the compounding process. The first is obvious — compounding may involve sacrifice (you can’t spend it and still save it). Second, compounding is boring — b-o-r-i-n-g. Or I should say it’s boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating!

In order to emphasize the power of compounding, I am including this extraordinary study, courtesy of Market Logic, of Ft. Lauderdale, FL 33306. In this study we assume that investor (B) opens an IRA at age 19. For seven consecutive periods he puts $2,000 in his IRA at an average growth rate of 10% (7% interest plus growth). After seven years this fellow makes NO MORE contributions — he’s finished.

A second investor (A) makes no contributions until age 26 (this is the age when investor B was finished with his contributions). Then A continues faithfully to contribute $2,000 every year until he’s 65 (at the same theoretical 10% rate).

Now study the incredible results. B, who made his contributions earlier and who made only seven contributions, ends up with MORE money than A, who made 40 contributions but at a LATER TIME. The difference in the two is that B had seven more early years of compounding than A. Those seven early years were worth more than all of A’s 33 additional contributions.

This is a study that I suggest you show to your kids. It’s a study I’ve lived by, and I can tell you, “It works.” You can work your compounding with muni-bonds, with a good money market fund, with T-bills or say with five-year T-notes.

See our future value schedule to test this calculation yourself.

Rule 2: DON’T LOSE MONEY:

This may sound naive, but believe me it isn’t. If you want to be wealthy, you must not lose money, or I should say must not lose BIG money. Absurd rule, silly rule? Maybe, but MOST PEOPLE LOSE MONEY in disastrous investments, gambling, rotten business deals, greed, poor timing. Yes, after almost five decades of investing and talking to investors, I can tell you that most people definitely DO lose money, lose big time — in the stock market, in options and futures, in real estate, in bad loans, in mindless gambling, and in their own business.

RULE 3: RICH MAN, POOR MAN:

In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that HE DOESN’T NEED THE MARKETS. I can’t begin to tell you what a difference that makes, both in one’s mental attitude and in the way one actually handles one’s money.

The wealthy investor doesn’t need the markets, because he already has all the income he needs. He has money coming in via bonds, T-bills, money market funds, stocks and real estate. In other words, the wealthy investor never feels pressured to “make money” in the market.

The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the “give away” table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are.

And if no outstanding values are available, the wealthy investors waits. He can afford to wait. He has money coming in daily, weekly, monthly. The wealthy investor knows what he is looking for, and he doesn’t mind waiting months or even years for his next investment (they call that patience).

But what about the little guy? This fellow always feels pressured to “make money.” And in return he’s always pressuring the market to “do something” for him. But sadly, the market isn’t interested. When the little guy isn’t buying stocks offering 1% or 2% yields, he’s off to Las Vegas or Atlantic City trying to beat the house at roulette. Or he’s spending 20 bucks a week on lottery tickets, or he’s “investing” in some crackpot scheme that his neighbor told him about (in strictest confidence, of course).

And because the little guy is trying to force the market to do something for him, he’s a guaranteed loser. The little guy doesn’t understand values so he constantly overpays. He doesn’t comprehend the power of compounding, and he doesn’t understand money. He’s never heard the adage, “He who understands interest — earns it. He who doesn’t understand interest — pays it.” The little guy is the typical American, and he’s deeply in debt.

The little guy is in hock up to his ears. As a result, he’s always sweating — sweating to make payments on his house, his refrigerator, his car or his lawn mower. He’s impatient, and he feels perpetually put upon. He tells himself that he has to make money — fast. And he dreams of those “big, juicy mega-bucks.” In the end, the little guy wastes his money in the market, or he loses his money gambling, or he dribbles it away on senseless schemes. In short, this “money-nerd” spends his life dashing up the financial down-escalator.

But here’s the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than he made, if he had taken his extra savings and compounded it in intelligent, income-producing securities, then in due time he’d have money coming in daily, weekly, monthly, just like the rich man. The little guy would have become a financial winner, instead of a pathetic loser.

RULE 4: VALUES:

The only time the average investor should stray outside the basic compounding system is when a given market offers outstanding value. I judge an investment to be a great value when it offers (a) safety; (b) an attractive return; and (c) a good chance of appreciating in price. At all other times, the compounding route is safer and probably a lot more profitable, at least in the long run.

Outside of banking circles, the Rule-of-78′s is little understood, even though it is commonly applied to many consumer and business loans. For the borrower, it tends to have a pernicious effect in the nature of a hidden prepayment penalty. The borrower’s disadvantage is heightened by the fact that the operation of the Rule-of-78′s is often referred to as a “Rebate of the Finance Charge.” Any consumer who heard the word “rebate” is always tempted to say, “Where do I sign?”

Not so fast!

Here’s how it works: The name comes from the sum of the numbers one through 12, there being 12 months in a year. Yes, that adds to 78.

The theory of the Rule-of-78′s is that at the moment a borrower signs the Note, the borrower is immediately obligated to pay back all of the principal and ALL of the interest that will accrue in the future over the agreed term of the loan.

Now, if the borrower prepays, the lender “generously” forgives some of the interest EVEN THOUGH at the time for it to accrue has not yet elapsed and so that additional interest has not been earned. That’s the so-called “Rebate.” Lenders argue that the uncertainty created about an early payoff entitles them to some compensation for being at the borrower’s whim for payoff. In a time of falling interest rates, that argument may have more merit than when interest rates are rising as the lender gets to put the money back to work at a higher rate and earn more.

In any event, the Rebate is calculated by summing the number of payments elapsed in inverse order as a numerator for the fraction in which the sum of the term is the denominator. That fraction times all interest over the life of the loan is the amount earned by the lender.

Watch this example:

Assume a two-year loan (so we’ll assume the numbers 1 through 24) for $10,000 with interest at 12% per year. Using our online amortization schedule calculator, we know the monthly payment is $470.73. The amortization schedule’s “Running Totals” also tells us that over the life of the loan the total amount of aggregate interest to be paid would be $1,297.56 (when the “1st payment date” is one month after the “loan date”).

After the fourth month, our borrower reaps a windfall and wants to prepay the whole loan. The fraction of the total interest earned by the lender is:

(Sum 24 to 21) over (Sum 1 through Sum 24)

90/300 = 30%

Now, let’s compare that to the interest actually paid to date to see what the penalty will be. From running the “Loan Table” module, we found the total interest to be $1,297.65 and the interest paid after four payments is $377.61, so the penalty is:

Earned Interest Per Rule:(30%)($1,297.65) = $389.30

Interest Paid to Payoff: $377.61

Additional Interest Owed: $11.69

Maybe that doesn’t look like too big a number, but it’s an additional 3.1% interest. Had this been a $100,000 loan, the increased penalty works out to ten times as much, $116.84.

Paying off at different times for different maturities and different interest rates produces differing penalty sizes. Two general rules of thumb can be deduced:

1. The higher the interest rate, the greater the penalty amount.

2. The earlier the prepayment in relation to the term, the greater the penalty amount.

So if you’re a lender, you should love using the Rule-of-78′s. If you’re a borrower, you should try to avoid it. A caution for lenders: Some states have usury and other laws that may limit use of the Rule-of-78′s.

©2001, Morris A. Nunes. All rights reserved.

NOTE:
a) This paper may be freely published provided that the above copyright notice is attached along with the appropriate byline. Portions may be quoted for illustration purposes.

b) Mr. Nunes can be reached at (703) 241-4917

• Take care of the dollar, and someday it will take care of you.
  -Unknown

• More people should learn to tell their dollars where to go instead of asking where they went.
  -Unknown
• If you can’t pay as you go, you’re going too fast.
  -Unknown
• How to handle money: use common sense. The simplest choices are often the best ones. Impulse is your enemy, time your friend.
  -Unknown
• Choose a job you love, and you will never have to work a day in your life.
  -Confucius
• A committee is a group that keeps minutes and loses hours.
  -Milton Berle
• First-rate men hire first-rate men; second-rate men hire third-rate men.
  -Leo Rosten
• A government which robs Peter to pay Paul can always depend on the support of Paul.
  -George Bernard Shaw
• Those that understand interest, collect it. Those that don’t, pay it.
  -Unknown
• What the wise man does in the beginning, the fool does in the end.
  -Unknown
• Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.
  -Shelby Cullom Davis

Feel free to add your own favorite quip or two as a comment.