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Basic Finance: Internal Rate of Return

This is the second in a series about finance. Because saving for a down payment can have such an enormously positive impact on which property you can buy, I thought I’d explain a few things about how to invest your savings as wisely as possible.

The idea of investing can feel quite intimidating, but once you know how to compare various investment opportunities, you’ll be able to figure out which ones will earn you the most money. Last week, I reviewed the concept of compound interest (earning interest on your interest). Now, let’s talk about how to measure your return—what you earn.

When you consider the best way to invest, you need to know how much you will earn over what period of time. Be cautious if any investment advisor who gives you gross return (overall earnings) numbers without including a specific time frame or someone who simply uses payback time to measure your return. These are methods used to conceal some aspect of the investment—to dupe unsuspecting investors.

With gross return, if an investment advisor says you’ll earn $1,000,000 over the life of the investment, but fails to mention what the term is, you may have to live to be 125 years old to enjoy those earnings. If an investment advisor tells you the payback time on an investment is three years, that sounds great—you’ve recouped your investment in three years. But what it doesn’t tell you is how much you could have earned on a different investment with a slightly longer payback time.

Because the idea of payback time is simple, I often hear people use this measurement when deciding whether to make a particular investment. Let’s say we invest in $10,000 worth of widgets. We get back $3,333 per year for three years the total investment is “paid back.” On the other hand, if you invested that $10,000 in something that paid you $3,000 per year for five years, your internal rate of return would go from zero to about 15 percent, a far higher return. This is why I avoid payback time as a measure of return. Using the payback method, you would choose the first investment instead of the one with higher return.

I mentioned “called internal rate of return” just now. This is the very best way to measure investments because it allows you to compare investments with different interest rates and payment schedules over time.

The internal rate of return is the rate at which net present value (today’s value) of a set of cash flows equals zero. The cash flows include two things: the initial investment (as a negative number) and the returns (as positive numbers). Confused? Let’s use an example to clear things up.

Let’s say you have $10,000 in your bank account and you want to buy a house ten years from now. You don’t know whether you should invest your money at 1 percent for ten years or 2 percent for five years. If you only cared about gross return, these two investments would be indistinguishable: they both earn $1,051. However, the internal rate of return looks at the time it takes to earn the money. If you can earn $1,051 in half the time and then reinvest your earnings, clearly the second investment (the one with the higher rate) is a better choice.

If you want to play with numbers (one of my favorite pastimes), there’s a great website that allows you to calculate all manner of things: calculator.net. You can calculate payments and returns related to mortgages, taxes, all manner of loans, investments, and more.

If you have questions about real estate or property management, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.