Given a choice, would you rather have one cookie now, or five cookies tomorrow?
Because most of you who read this blog on a regular basis are sane, rational people who keep your avarice in check and are familiar with delayed gratification, you’ll choose five cookies tomorrow.
There have been real research studies that ask people that same question. American Renaissance has cited these studies and their results to prove that our bretheren of color cannot conceptualize the concept of delayed gratification and future return on investment, as invariably blacks are far more likely than whites to want the one cookie now. To clarify, AR contended that this is an issue of low intelligence, not a conscious decision to be greedy.
Let’s apply this to the Powerball jackpot.
Nobody won the $300 million jackpot this past Wednesday, so the jackpot for this Saturday’s drawing is $365 million.
Two days ago, I was in a situation where I was able to overhear two men, both African-American and middle-aged, talk to each other about the Powerball, the afternoon before the drawing for the $300 million. During their conversation, the issue of the jackpot prize came up.
The Powerball will allow you, if you win the jackpot, to choose between the full jackpot amount prorated over 30 years, or about half of the jackpot amount right now. For instance, Wednesday’s pot of $300 million could be taken for $10 million a year for 30, or about $150 million right now.
One of the men told the other that the up-front option was a ripoff, because (pph), “they’re ripping you off of half of the money.”
The man that made that statement, like most readers of this blog, but unlike many of his racial bretheren, knows the value of delayed gratification to the tune of an extra $150 million. I would imagine that most of you would take the 30 year option for that reason.
BUT: If you are the kind of person that wants or needs it NOW, then it’s actually a very good deal.
“Huh? How can you say that? They’re only giving you half of what you would get.”
Yes, that’s right.
But there’s this thing in the world of finance called the Time Value of Money, or TVM for short.
When you go for a loan, you know how much you have to finance, what the interest rate is, and how long it will take to pay the loan off. Using a not-so-simple equation, one that is too complex to put here, your monthly payment is calculated. This equation is known as the TVM equation.
If you have a good programmable calculator, like I do (Texas Instruments TI-86) or a business calculator with TVM functions built-in, considering all four values in a loan (number of months in the repayment, the principle financed, the interest rate, and the monthly payment), if you know three of the four, you can calculate the fourth. This is what your friendly banker does for you when you apply for that mortgage; everything but monthly payment is known, and Mr. Computer calculates that amount.
Sometimes, a situation arises where the unknown value is something other than the monthly payment.
To see why the up-front Powerball prize is a good deal, we have to work backwards in the TVM equation.
For this coming Saturday, the Jackpot is $365 million. If you choose the up-front option, you get $177.3 million in one felt swoop. Otherwise, you get about $12.16 million a year for 30 years.
Let’s say you go to a bank and take out a loan for $177.3 million, to be repaid over 30 years, i.e. 360 months. You get the loan, for an unknown interest rate. When Mr. Banker plugs in the principal, the number of months and the interest rate into the computer, your monthly payment will be $1,013,888.89. Over the life of the loan, you will have paid $365 million to the bank over those 30 years.
Now, work backwards. Plugging the three known variables here yields that the interest rate is: 5.56%.
Therefore, if you take the $177.3 million now instead of $365 million over thirty, you’re conceding an interest rate of only 5.56%.
I did some research, and today’s average, in the St. Louis Metro Area, for a 30-year fixed, non-jumbo, 1.000 point, 90% LTV mortgage is 5.78%.
Compare this to the fact that people WILLINGLY agree to credit card interest rates (on paper) of upper teens and low twenties of percent in interest, and to terms in the credit card contract that are so onerous that, if one gets a little behind, then the vicious circle of late fees and interest rates will ramp up that, in a real-world example I know, a person had two credit cards that had effective interest rates of 211% and 237%.
Compare this to the fact that people will go to fly-by-night “rent-to-own” joints that, not only overinflate their “retail” price for their several year old merchandise, but then on top of that offer credit terms that mean effective interest rates in the 200s and 300s in percent.
Compare this to the fact that some banks in St. Louis are now offering 12-month CDs in the 4.7% neighborhood.
Compare this to the fact that, at the moment, the Prime Rate (the market rate that banks charge its best and most creditworthy customers for loans) is 7.50%.
For those of you who are familiar with the TVM equation and proficient in algebra, you know the reason why loans with long terms, like mortgages, will mean that a borrower will have paid so much back to the bank that, by the end of the loan, he or she will have given the bank in aggregate twice or three times the original loan principle. The reason is, looking at the TVM equation, the “number of months” variable is in such a place to where it wields the most algebraic leverage over the rest of the equation.
This is why you get so “little” up-front in one lump sum instead of the whole jackpot over thirty years, if you choose that option. It’s just the “number of months” variable working in the opposite mathematical direction.
With all this having been established, what Powerball is offering is a very fair deal, if and only if you want it all today.
As for me, I can’t wait until tomorrow.