Category Understanding the Mathematics of Personal Finance

Taxation and Inflation

John Lennon once said, “Life is what happens to you while you’re busy making other plans.” Both taxation and inflation, it seems, are parts of life—they happen to you while you’re busy making other plans.

Taxation is the government’s way of getting money to pay its bills. You pay taxes on, among other things, your income; earned interest may be considered part of your income. The government (federal, state, and local) all want a piece of this income, so you get to keep and spend or save less than what all of the calculations thus far have promised you. On the other hand, interest on some of your debts is considered to be a deductible expense. That is, you get to reduce the income you report to the government, from which your tax burden is calculated, by this interest.

Inflation...

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PARI-MUTUEL BETTING

The pari-mutuel machine system used at race tracks offers a different approach to gambling. A roulette wheel owner is never sure what his or her daily operating cost will be; he or she only knows statistical generalities. On some nights, almost no one could win a lot of money; on some nights, there could be several lucky people. Also, the probabilities are fixed going into the game. The probability of the roulette wheel ball landing in any one slot is just 1/(number of slots) and the payoffs on any type of bet are published. The pari-mutuel machine system, on the other hand, adjusts the payoffs based on the bets, and the track owner can take a fixed amount or a percentage of the bets from each race. The easiest way to explain this is to work through an example.

Look at Table 14.1...

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Prepayment Penalties

When you take a loan, the lender has legitimate up-front costs in preparing the paperwork, setting up the account, monitoring the payments, and so on. In the case of a mortgage, as shown in Chapter 4, the lender usually manages to charge you for these costs. In the case of an auto loan, there might not be any up-front costs. Instead, the lender estimates his or her costs and wraps them into the interest rate for the loan. This is equivalent to what I have shown at the end of Chapter 4; it’s just not shown explicitly—you’re quoted an interest rate and that’s that.

Suppose you were to acquire some money you didn’t think you’d have, or you have the savings, or for whatever reason you decide to pay the loan off early...

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DECREASING TERM INSURANCE

Another type of term life insurance is decreasing term life insurance. A decreasing term life insurance policy pays a little less each year for the term of the insurance. As an example, consider a $100,000, 20-year decreasing term policy. In year 1, the policy pays $100,000. In year 2, it pays $95,000 and so on, up to year 20, when it would pay $5,000.

At first blush, this seems like an odd sort of life insurance. Why would you want a beneficiary to receive less if you die later? This type of insurance is the equivalent of the loan insurance described in the last section, but it is more appropriate when it’s insuring a loan that is being paid off over time. If you are paying a loan back with regular payments, then each month you owe less...

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A BANKRUPTCY SPIRAL

Table 6.5 shows a month-by-month account of how things can go very, very, wrong. In doing the calculations, I’m just looking at monthly updates—I’ll assume that you

Table 6.5 A Credit Card Disaster

Month

Balance ($)

Interest ($)

Tot Int ($)

Pmt

$200.00

0

254.50

2.00

2.00

Charge

$450.00

1

511.55

7.05

9.05

2

771.16

5.12

3

1,033.37

7.71

4

1,298.21

10.33

5

1,565.69

12.98

6

1,835.84

15.66

27

8,176.86

78.44

28

8,513.12

81.77

29

8,852.75

85.13

30

9,195.78

88.53

31

9,542.24

91.96

32

9,892.16

95.42

33

10,245.58

98.92

34

10,602.54

102.46

35

10,963.07

106.03

36

11,327.20

109.63

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Investing: Risk versus Reward

If you kept all your savings in cash in a shoe box under your bed, you would be risking loss due to theft, fire, and so on. On the other hand, while your savings would never add up to anything other than exactly what you put into the shoe box, from a financial point of view, your savings would be absolutely safe. No stock market variations, bank failures, or whatever could impact your savings. Inflation, however, would slowly eat into the actual value of these savings, even though the dollar amount didn’t change.

Government-insured savings are, for all intents and purposes, perfectly safe. In addition, when your money is put into an insured saving product, you don’t have to worry about a burglar making off with it in the night...

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