Basic Concepts: The Time Value of Money

After graduating from the University of Texas with a degree in Finance, Stan Morgan took a position as a stockbroker with Morgan Stanley in Austin. Although he had several college loans to make payments on, his goal was to set aside funds for the next eight years in order to make a down payment on a house. After considering the various suburbs of Austin, Stan chose Round Rock as his desired future residency. Based on median house price data, he learned that a three-bedroom, two-bath house currently costs $275,000. To avoid paying Private Mortgage Insurance (PMI), Stan wanted to make a down payment of 20%.

Because it will be eight years before Stan buys a house, the $275,000 price will surely not be the same in the future. To estimate the rate at which the median house price will increase, he considered the historical price appreciation in Round Rock. In the past, homes appreciated by 4% per year. Stan was satisfied with this estimation.

Morgan Stanley offers several opportunities for Stan to invest the funds that will be devoted to the purchase of his future home. He feels that a balanced account of stocks, bonds, and government securities would realistically achieve an annual rate of return of 8%.

Question:

1. If Stan decides to make end-of-the-year deposits into the Morgan Stanley account, how much would these deposits be?

2. If Stan decided to deposit his down payment funds in riskier high-growth investments that have an expected return of 12%, how much would he have to deposit at the end of each month the make the down payment? Use the down payment needed from number 2 for this calculation.

3. If Stan decides to make end-of-the-year deposits into the Morgan Stanley account, how much would these deposits be?

4. Based on your calculations, should Stan make end of month or end of year deposits? Why? Do you recommend he deposit his funds in the balanced account with 8% expected return, the low growth investments with 4% expected return, or the high growth investments with 12% expected return? Why?