Student Question from: Susan M.
Course: Fundamentals – Calculator
In example 3 (shown below), why do we use monthly instead of annual for the interest and period of time?
- Example 3: Bill wants to purchase enough life insurance to provide his family with an inflation-hedged income of $4,000 per month for 25 years. You and Bill agree that inflation should average 3.5% per year and that the life insurance capital should be able to earn 6% per year. How much life insurance does Bill need?
Very good question, Susan. The first sentence of the question states that he would like to provide monthly income of $4,000. This indicates that we are doing a monthly calculation. If you apply the annual interest to monthly payments, they will be greatly inflated. You must do both monthly interest periods of time. So our interest entry is divided by 12, and the time period (n) entry is multiplied by 12.
Great question to ask because this is good practice for CFP Board questions. The Board will not say, “Oh by the way, calculate everything in this question monthly.” You have to find clues in the question to determine the appropriate entries.