August 5, 2008

How to adjust for inflation?

Generally when we talk about financial planning we do not typically adjust numbers for inflation. If someone discusses the power of compound interest they might state how $1,000 invested annually at x% over 40 years could grow to over $1 million dollars. But $1 million dollars 40 years from now won't be worth the same as $1 million is today. So it can be important to adjust our figures to take into account the impact that inflation has.

There are a couple main ways that I'd use to adjust for inflation. 1) use an online calculator service or 2) crunch the numbers manually.

Using an online calculator

The BLS has an inflation calculator that you can use to figure out what a dollar value from a previous year would equate to in todays dollars. So for example if your father bought a house in 1962 for $15,000 you could plug in $15000 for the dollar amount at 1962 for the year and it will tell you that it would be worth $108,682.95 in 2008 dollars.

The calculator at MeasuringWorth will let you take a dollar value from one year and equate it to a value from another year. You can either go backwards or forwards.

These calculators are handy if you are looking to adjust the value of values from the past to equate them to todays dollars.

Calculating inflation adjustment manually

You can calculate an approximate inflation adjustment manually by using a set value for inflation over time.

To find the present value of future amount:

Present value = Future amount / (1 + % inflation ) ^ number of years

For example if you assume a future inflation rate of 3% annually and you expect to have $1 million dollars 40 years from now then the calculation would be:

present value = 1,000,000 / (1+.03)^40 = 1,000,000 / 3.262 = $306,556

On the other hand to find the current value of a past amount you simply flip the formula around:

Future amount = Present value * (1+ % inflation) ^ number of years

So for example if we have $1,000,000 today and we want to see what that would equate to in 2048 if we assume 3% inflation then the calculation would be :

future amount = $1,000,000 * (1.03) ^ 40 = 1,000,000 * 3.262 = $3,262,000

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