Beware Online Calculators!

by Dual Income No Kids on July 7, 2008 · 0 comments

Hi All,

This posting is a quick rant about one of my personal finance pet peeves: on-line calculators. A lot of people use on-line calculators to help them make financial decisions. However, they fail to realize that many on-line calculators are only crude approximations of financial reality.

There are at least two problems with many on-line calculators.

1) Reliance on Compounding Assumptions:

Many calculators assume that compounding occurs linearly over time. Right, you plug in your numbers, assume some given interest rate per year and at the end of a period of time, you will have some amount of money. This, unfortunately is at odds with reality. In reality, people are much more erratic in their savings behavior. Think about it, your bank changes interest rates and you probably don’t save the same amount each month. To assume that your interest will compound over time at the same rate every year is not tenable.

2) Ignoring Inflation:

Inflation occurs when there is a sustained rise in prices over a given time. It has the insidious effect of reducing the long term purchasing power of your money. This is a problem because many calculators do not account for inflation. Lets say for example that you have the goal of saving $40,000 to buy a house. Well, if you relied on a simple compound interest calculator in a high inflation environment, it turns out that instead of $40,000 you might actually need $45,000. The difference is due to the loss in purchasing power of your money due to inflation. this is a problem because when you take your $40,000 to market, you might find its not enough to get the job done.

If you do want to make reasonable assumptions, be sure your calculator accounts for both real world contingencies and inflation. Click here and here to get started.



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