10 Simple Money Formulas Everyone NEEDS To Know

the world of personal finance can seem overwhelming at times especially for newcomers not only does it seem like there's a fancy new investment opportunity or crisis every other day but even things that seem simple at first such as how to best pay off a loan or what portion of your income should be saved can get very complicated very quickly due to the personalization effect with that in mind today we're going to be going over 10 money formulas that i believe everyone should know in order to give you a better financial foundation to build from going forward while these formulas won't suddenly make all of personal finance simple and straightforward i hope that they will help you better navigate some of the more common financial questions when you run into them but before we get going be sure to like this video if you haven't already as it really does help out the channel a lot and subscribe with notifications on for more money related videos like this one every single week and if you want to further support this channel you can check out some of the links i've left in the description below which includes a link to my patreon page this is the best way to show your support for this channel and in addition to that you can also get early access to new videos and exclusive content such as spreadsheets based off the ideas we discuss in these videos spreadsheets will allow you to play with your own numbers and see how big of a difference some of the ideas we discuss can make for your own personal financial situation the first few formulas are some of the most basic ones you'll run into in the world of personal finance they're meant to show you where you are right now where you want to be in the future and whether or not you're currently on track to reach your goals the first formula is used to help you determine your current net worth after all it's hard to make a good financial plan if you don't know where you're currently sitting financially and that's exactly what this formula tells you it's calculated by finding the difference between all of your assets traditionally defined as everything you own and all of your liabilities traditionally defined as everything you owe i say they're traditionally defined that way because while accurate and helpful in a number of situations those definitions can sometimes be a little misleading this is mainly because not everything you own is actually actively pushing you forward financially think of a home it's traditionally viewed as an asset but unless you sell it or rent it out in some shape or form it doesn't do much to push you forward financially in the here and now in and of itself some people like robert kiyosaki in his book rich dad poor dad suggested an alternate definition for assets and liabilities which can be useful to examine in certain situations he argued that assets are anything that puts money into your pocket and liabilities are anything that takes money out of your pocket by that definition homes can be assets in some cases such as if you're renting it out but they're also always liabilities as it costs money to own and maintain a home even if the mortgage is technically paid off the second formula known colloquially as the four percent rule shows you where you may want to be in the future the four percent rule is a simple rule of thumb popularized by retired financial advisor william bengan that tells you how much money you can sustainably withdraw from a nest egg in retirement and by extension how much money you'd need to have saved in order to safely retire it like every other rule of thumb is not going to apply to every single situation or edge case but it can be a good starting point to give you an idea of what you may want to be shooting for the rule states that assuming you have a well-diversified investment portfolio you should be able to withdraw about four percent of your savings in the first year of retirement and then adjust that withdrawal amount every year thereafter for inflation as measured by the cpi based on bengen's study he found that a portfolio equally split between stocks and bonds would have lasted at least 30 years before running out of money regardless of whether you started withdrawing in 1929 before the onset of the great depression or in the early 1990s before the incredible run-up preceding the dot-com crash what this means is that you'd want roughly 25 times your annual expenses that aren't covered by non-investment related income sources like social security saved up before retiring as that would allow you to cover your retirement costs with your nest egg now as we've covered extensively on this channel there are a lot of things you can do to either increase or decrease your safe withdrawal rate but again it gives you something to shoot for as you continue to build up your financial knowledge base and fine-tune things to your situation the third formula is perhaps the simplest of all it shows you whether you're on track or at least whether you're making progress towards your financial goals it's known as the cash flow formula and simply measures the difference between your income and your expenses some people will measure the difference between their net after tax income and their expenses which can also be helpful another potentially useful formula in this cash flow category is your fixed spending ratio which simply measures the portion of your spending that's attributable to fixed unavoidable costs in other videos on this channel i often refer to these kinds of costs as your burn rate expenses or the expenses that you can't reasonably get by without making others like dave ramsey refer to them as the four walls of your financial house these expenses include but may not be limited to things like your shelter costs you know rent mortgage property taxes so on and so forth food water utilities transportation clothing and probably insurance this is a good number to be aware of because the lower it is the more financial flexibility you're likely to have should things really go south for a while related to the idea of the fixed spending ratio from the last section are the ideas of financial sustainability and risk financial sustainability can be measured with the financial runway formula and financial risk can be measured in many ways but one aspect of financial risk is your debt load often measured by some form of leverage ratio and the duration of said loans the financial runway formula tells you the number of months or years that you could cover your expenses if you suddenly lost your job or ability to earn an income by comparing your liquid monetary assets in other words not including things like the value of your home or car that might be difficult or costly to sell quickly to your monthly or yearly expenses and while not exactly the same thing you'll sometimes hear this idea referred to as a liquidity ratio due to its similarities to the accounting measurement used in the business world the difference is that the liquidity ratios tend to measure the ratio of the businesses liquid assets or a subset of them in the case of the cash or quick ratios relative to its short-term liabilities whereas one's personal financial runway doesn't care about whether reliability is short or long-term or really whether an expense is a liability or just a discretionary purchase they're all treated the same in the formula you could also modify this formula to look at just your burn rate expenses to give you an idea of how long you could last if you really hunkered down your personal leverage ratio can help give you an idea of your current debt load and is often one of the formulas used in the mortgage application process to determine what kind of loan you qualify for it's calculated by dividing your total debt by your net income beyond the leverage ratio you can use the minimum payment formula to determine how much extra weight a debt would add to your financial shoulders it's calculated as follows the i in the formula represents the interest rate on the loan for each payment period and the n represents the number of payments to be made on the loan so for instance a thirty thousand dollar four-year car loan charging three percent interest would come out to be about 664 dollars and three cents a month the interest rate is converted to the monthly rate of 0.25 due to the fact that monthly payments are being made in this example this formula in tandem with leverage ratio formula can really put into perspective whether taking on a new loan is worth it for you financially if you're otherwise debt free and are netting a hundred thousand dollars a year then a 664 a month car payment may seem easily doable on the other hand if you already have loans equating to a year's worth of income and you're only netting like 40 or 50 000 a year then adding a car payment of this size may not be the best move investing related formulas could be a whole video onto itself but for today i'll keep it to some of the more common ones perhaps the most common family of investing formulas is the return on investment tree return on investment can be measured in any number of ways from the short-term changes in the investment's price and income figures to the combination of all forms of financial growth known as the investment's total return you can also measure things like compounded returns over time or inflation-adjusted returns over time the short-term returns are fairly easy to calculate if you're looking at price changes you can simply take the price gain or loss on the investment divided by the original price of the investment and multiply the ending result by 100 to get a percentage so if apple stock was worth 132 a share a year ago which at least at the time i'm recording this in december 2021 it was and it's trading at around 170 a share now its gain would be 38 dollars per share and its price return would be about 28 as shown here for total returns you can do something similar except instead of dividing the price gain by a prior price you divide the current gain or loss on the overall value of an investment by a previous value of the investment and then multiply it by a hundred so if you had invested ten thousand dollars in apple stock a year ago you'd have benefited from that price growth but you may have also earned a small amount in dividends based on the figures at the time of this recording anyway your ten thousand dollar net worth would have grown to a bit under thirteen thousand dollars today meaning that your total return would be just under thirty percent for the year which is really good long-term compounded returns get a bit trickier but it is still fairly manageable using the formula you see on your screen now the a represents the ending value of the investment the p the starting value of the investment or principal the r is the annualized rate of return on in the investment and the t is the time you'll be invested this is usually measured in years but can sometimes be measured in months or even days and finally the n represents the number of times per period as measured by t that the investment compounds so if t is measured in years like it usually is n indicates how many times per year the investment compounds if t is measured in months then n represents the number of times the investment compounds per month compound interest is one of the first things that many of us learn when it comes to our finances and there's a great reason for that it can radically change your life if you put it to good use for example a ten thousand dollar investment earning ten percent each year will rise in value by a thousand dollars in that first year since that's ten percent of ten thousand dollars however due to the effects of compounding in the second year it'll be earning 10 interest on the value of the investment at that time which would be 11 000 in this case assuming you didn't take any money out shoot forward a few decades and the interest and appreciation received on your investments can easily outstrip your regular income from working all year as seen in this chart and that's without adding any money to the investment over time but the thing to remember about compound interest is that it doesn't just refer to interest earned on investments it refers to any interest that compounds over time including loans so it's important to make sure that compound interest is working for you and not against you finally there's inflation adjusted returns which can measure how your buying power or what you can actually get with the money you have is changing over time it's calculated using the following formula i should note that the reason you don't simply subtract the inflation rate from your rate of return for the year is because over time the compounding effect of both inflation and returns would eventually throw off your results take a look at this hypothetical example to see how it works originally cookies cost one dollar per box and your 100 nest egg would theoretically have been able to buy you 100 boxes of cookies at that price over time your investments grew by 10 per year and the cost of cookies rose by 5 per year you'd think that would mean that each year you'd be able to buy five percent more cookies since that's the difference between your investment growth and the rising cost of cookies but as you can see by this chart that isn't actually the case your buying power measured here by the number of cookies you're able to buy is growing by about 4.76 per year another quick and dirty formula you can use to calculate investment growth is the rule of 72. in a nutshell the rule of 72 says that if you divide 72 by your rate of return it'll tell you approximately how many years it will take a lump sum investment to double in value the nice thing about this is that it allows you to measure the growth of an investment in both nominal and real terms if you want to see how long it takes your investment to double in value on a nominal basis simply input your total return in place of r in the formula if you want to measure the growth of your investment on an inflation-adjusted basis simply put in your real rate of return here's a chart showing the rule of 72 in action using a ten thousand dollar initial investment and return assumptions of six percent eight percent and ten percent per year the downsides are that obviously most investments don't produce returns that are this consistent so the growth of your net worth isn't likely to follow this exact path even if it does end up at roughly the same point by the end of the time frame and the formula doesn't do much to tell you how long it would take an investment to double in value if you were regularly adding money to it like we often do with our 401ks and iras at work here's how the same chart would look if we were regularly adding 500 a month to our investments and finally we get into a couple of the more perspective based formulas these are always fun as they can really make you see your financial decisions and situation a little bit differently there are many formulas that i could have covered in this section similar to the investing section they could realistically fill their own video but i decided to go with the money as hours of life equivalent formula and the lifetime wealth ratio the money as time equivalent is a family of formulas that try to convert your financial decisions in such a way that you're measuring the time cost of the decision as opposed to the financial cost of the decision for instance if you're taking home thirty six thousand dollars a year or three thousand dollars a month then a one thousand dollar iphone costs you roughly three percent of your working year assuming you work 40 hours a week 50 weeks a year that would mean that it would take you about 55 hours to pay for that phone the formula can similarly be used to measure the value of financial decisions like investing as we saw earlier due the effects of compound interest over time the gains you see in your investments can grow to replace much if not all of your working income if you have three hundred thousand dollars in investments that typically earn five percent per year and you're taking home 36 000 a year in salary then your investments essentially provide you the equivalent of an extra 833 hours of work each year the formula isn't trying to tell you whether or not the phone is a good purchase or whether you should be investing more it's just trying to get you to think about the purchase from a different perspective and for me at least it really drives home the value of being intentional with your money the lifetime wealth ratio according to its creator j jmoney from budgetsexy.com measures your net worth relative to your total lifetime income it's a great way to measure your financial efficiency and develop an appreciation for those that may not have had million dollar net worth figures but nevertheless have managed to do a lot with what they did have because obviously we'd expect a corporate executive making high six figures every year to have a higher net worth than someone of a similar age who never made more than 40 or 50 000 in a year it's not always how it happens of course but it is what we would expect to see more often than not there's just more money left over after taxes and necessary living expenses like shelter to put towards investments and while the lifetime wealth ratio will still skew towards favoring those with higher incomes more often than not because of that reason it does at least give us a little bit of a better perspective on how efficiently someone turned their income into financial wealth so those are 10 money formulas that i feel everyone should know obviously this list isn't exhaustive there are some areas that are hardly if at all touched on such as formulas related to running a successful business like profit margins break-even points liquidity and solvency ratios so on and so forth but this should give you a good foundation for a simple financial life that you can get by on and hopefully build on going forward it gives you an idea of where you are and how you're doing right now financially it gives you an idea of a target to shoot for going forward all while getting you to think about financial risks and sustainability and illustrating the power of intentionality persistence perspective and time but that'll do it for me today once again if you enjoyed this video be sure to smash that like button if you haven't already subscribe and hit that bell next to my name so you'll be notified of all my future uploads i generally upload every single monday and if you have a friend that would be interested in this kind of content be sure to share it with them let's really get this information out there and start our own financial revolution

Channel: Next Level Life

Views: 32,435

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Id: t_i73gcwi1U

Length: 15min 33sec (933 seconds)

Published: Mon Apr 04 2022