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How Financial Planning Calculators Work

Getting your finances in order can sometimes be easier with a little Web-based assistance.
Getting your finances in order can sometimes be easier with a little Web-based assistance.
©iStockphoto.com/fotek

A complete financial debacle can make even the most money-savvy among us re-examine our pecuniary health. It can send the average investor, saver or planner into a tailspin quest for a crystal ball.

Enter the financial-planning calculator. When the economy turned in the first decade of the millennium, these easy-to-use predictors vastly expanded their online presence. Now, they're featured not only on bank and investment-house Web sites, but they've also become more common on the Web pages of individual accountants, financial planners, government sites, colleges and money blogs.

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Lots of people concerned about their financial situation, or simply initiating or revising a financial plan, are turning to these tools to help them reach their financial goals. It's no wonder: You input some data and a computer program spits out what you should do in order to reach a secure retirement, save effectively for college, apply for the right mortgage, invest in the right stocks and successfully choose the right path in countless other areas of financial planning.

But there's a catch: They're not always right. Sometimes, the programs themselves are flawed, or they rely on financial predictions they don't disclose. And even when the program is relatively sound and transparent, the more potentially accurate the output, the more complex the input requirements, resulting in an experience that turns out to be sadly subject to user error.

Still, financial calculators do have a pretty solid place in creating a reasonable financial plan. In this article, we'll find out what online financial calculators can do and how to use them to your advantage. We'll examine the pros and cons of the tools and see what users should look out for when working with these automated tools. They're far from crystal balls, but considering they're typically free to use, they're a lot cheaper than the human version.

Or are they?

Financial planning calculators help supplement the old five-function models as part of your financial arsenal.
Financial planning calculators help supplement the old five-function models as part of your financial arsenal.
Photo courtesy of Michigan.gov

It's certainly a tempting prospect: a free program you can access from the comfort of your own home, input a few basic bits of information, and find out what you need to do to achieve financial security.

While it's not really that straightforward (more on the shortcomings on the next page), an online tool can definitely be a big help in making financial plans, especially if you're at a bit of a loss for where to begin. Lots of us have our bank statements, tax returns and stock-dividend notices in our file drawer with no idea how to combine that information to reach the most basic overall financial strategy.

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There are countless versions of the financial-planning calculator out there, ready to advise on the most specific financial question. Some come in software form, and some are actual physical calculators. But the ones gaining the most attention these days are the free online tools. Just a few of the online calculators you'll find on two popular money-oriented Web sites, CNN Money and ABC News Money, will estimate:

  • Return on a mutual-fund investment if you sell now
  • How exchange rates affect potential foreign stock investments
  • Returns on tax-exempt vs. nonexempt bonds
  • Whether a credit card's annual fee will save you money in the long run
  • How much you'll pay to raise a child
  • The effects of inflation on personal savings
  • How much you need to be putting away so you don't outlive your retirement savings
  • How much you'll earn in the long run by reducing your spending now
  • How much mortgage you can afford
  • Whether and how much you'll save by refinancing your mortgage
  • Whether you should save or spend your tax refund
  • How much you can afford to borrow for college

These types of computerized calculations can be a great way to start thinking about a financial strategy -- but the key word here is "start."

A financial planning calculator will only be as accurate as the information it's given.
A financial planning calculator will only be as accurate as the information it's given.
Photo courtesy of Chatanooga.gov

An online financial-planning calculator is a useful tool, but it's not foolproof. It's not even close.

A program based on hypotheticals is not always going to be accurate. It could assume a certain rate of inflation that turns out to be way off. Or it could place too much weight on an estimated life expectancy that is really only correct 50 percent of the time [source: Today's Seniors].

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That's the biggest risk factor in relying too heavily on these tools: They're necessarily based on assumptions (and often on only partial data, to simplify the process). The built-in criteria they're using, which you may not always be aware of, may or may not prove accurate in the long (or short) run.

Another significant problem with this type of user-guided financial tool is the "user" part. The more accurate calculators are more intricate in their calculations, and they require a fair amount of data input. Some of this data may actually require some understanding on the part of the user -- understanding that user may or may not possess. So user error can play into the equation, too.

Ultimately, the smartest use of an online financial-planning calculator is as a jumping off point. It can establish a guideline for your finances, which you then take to a certified accountant or financial planner for expert advice in confirming the calculator's output (and your own data input).

Or, if you're dead set against paying for a human second opinion, at least get a second and third automated opinion. If several calculators return the same approximate result, you can probably move forward with some degree of confidence that your information is sound.

For more information on financial planning and related topics, look over the links on the next page.

Related HowStuffWorks Articles

Sources

  • Dull, Richard B. and Lydia L.F. Schleifer. "Online Financial Calculators." The CPA Journal. 2003.http://www.nysscpa.org/cpajournal/2003/0703/features/f073003.htm
  • Personal Finance Calculators. ABC News Money. Nov. 28, 2005.http://abcnews.go.com/Business/Calculators/story?id=133188
  • Planning Tools. New York Life.http://www.newyorklife.com/nyl/v/index.jsp?vgnextoid=1740a2b3019d2210a2b3019d221024301cacRCRD
  • Retirement Calculator. Today's Seniors.http://www.todaysseniors.com/pages/Retirement_Calculator.html

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