Regular readers will by now know my frustration with the failure of the school system to adequately teach financial and people skills.
These two areas are possibly the most important needs in one's life. Never in my 70 years has the need for good financial skills been more important than now.
The jump in land and house prices has been large and affordability has been placed under huge pressure.
Compounding and discounting are two fundamental skills you must have if you are making large financial decisions.
With inflation eating away at our money, a dollar today will not be worth a dollar tomorrow.
In basic terms, compounding is money growing on itself while discounting is the present value of a future lump sum.
In the 1980s and 90s, loans were granted on a 20-year term basis. With land and house prices much higher, these have been stretched to 30 years to enable affordability. The annual payments will be much less across 30 years but the total amount paid will be much greater.
For every million dollars borrowed at 6 per cent you will pay $87,200 of principal and interest annually across 20 years and $77,600 each year for 30 years. At the end of the 20-year term, the total cost will be $1,744,000 and $2,328,000 for 30 years.
With capital growth on your land at 6pc, the interest rate is cancelling out the growth. Across 30 years, the interest bill is nearly 1.5 times the principal amount borrowed.
I can recall when I returned to the family farm in 1982, we did our budgets for Australian Standard White wheat at $150 a tonne. Now it would be $320/t. This represents an annual average of 1.8pc compound growth across the 42 years - well short of inflation.
My local hamburger shop charged 1 shilling in old currency or 10 cents for a plain hamburger in 1957 when the shop opened. Last year it cost $10 for the same item - a 100-fold increase or 7.1pc average annual increase across 67 years.
With many young wage earner couples not buying their first home until they are in their 30s, they could find themselves paying off their home right up to the point of their retirement. With past and current superannuation contributions falling short of requirement, still having a mortgage at retirement is not a savoury thought.
Discounting is just as important to understand as compounding.
For projects that will not return income for some time, you need to discount future income and expenses back to a current day value so you can make a sound judgement. If inflation is running at 4pc, $1 million will only have a purchasing power of $675,000 in 10 years' time.
With larger long-term projects, future lump sums need to be discounted at much higher rates, not only to account for inflation but also higher risk. No one really knows what the future will hold but history tells us nothing stays the same. Everything fluctuates with supply and demand.
Let us look at a farmer with assets worth $25m and the land component of $20m. Compounding the land at 6pc per annum and being a very good farmer, a trading return on assets of 9pc, which are retained and keep growing at the same rate, their business potentially could be worth $300m dollars in 20 years' time.
Naturally some of the profit will need to be spent on various things along the way but $250m of total assets in 2044 is a real possibility.
This is not a field for the financially illiterate.
- Details: kensolly@rbm.com.au