Monday, September 27, 2010

The Real Cost of That Guarantee

Just imagine that you had $10,000.00 to invest right now. Where would you invest it? Let’s say that you found a great deal at the bank – a CD with a guaranteed 5% annual rate of return. That sounds like a great deal, doesn’t it? Now, just for fun, let’s figure out how much you would make if you decided to take the bank up on their guarantee for one year:
  • First let’s multiply the $10,000.000 by the guaranteed 5% rate and this gives you your one year profit of $500.00. Not too shabby.
  • Next let’s multiply your one year profit of $500.00 by 25% (the amount of taxes you will need to pay to pull out this profit) that results in $125.00. Subtract the taxes paid from the first year’s profit ($500.00 - $125.00) and you still have a $375.00 profit. Still, not that bad.
  • Finally, let’s take inflation into account. With 4% inflation, your original $10,000.00 is worth $400.00 less now than last year. So, let’s subtract the loss in buying power due to inflation from the profit that was adjusted for taxes ($375.00 - $400.00). Your final profit -$25.00! What happened?
What happened here is what happens to a lot of intelligent people – they don’t take into account all of the factors, such as taxes and inflation – because they were never taught how to. And I think this is very important for everyone to know! The real cost of the guarantee, in this case, would be a loss of $25.00 worth of buying power! So, it turns out that it was a great deal after all … for the bank!

Important Note: Typically, whenever a financial institution is willing to “Guarantee” you a rate of return, it will be a guaranteed loss to you, when you take into account “Taxes” and “Inflation”. Next time you are enticed to take that guarantee, try out this little exercise to figure out if it is going to benefit you … or just the bank. Don’t forget about the taxes and inflation!

I like the way The Motley Fool puts it: “Over time, of course, the market has historically been the best place to park your money. [T]he so-called 'safest' investment vehicle – putting your money in an interest-bearing bank account, or in a money-market account – is in a very real sense the most guaranteed losing proposition of them all (short of stuffing your savings under your mattress, and watching it eaten away either by mice or by the sharp teeth of gnawing inflation).

Why is this? Because if you’re getting, say, a guaranteed 5% a year, then you are missing out on the average 10.6% that an index fund, like one that tracks the performance of the S&P 500, would have been gaining for you. It’s true that you’re protected from losing your principal if you take the bank account-conservative route – but you’re also 'protected' from any major long-term investment returns.”

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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