Chapter 1. Basic concepts: Compound interest & time value of money
Before you make any decisions on how to save or invest your money, there are a few financial concepts one must first grasp. It requires you to take the time to fully understand what these concepts mean and how you can use them to your advantage.
How to
1. Compound interest
If you invest your money using the simple interest method, you calculate interest on the initial principal only. But, when you use compound interest, you earn interest on the initial principal in the first year and then interest on the principal plus the prior year interest in the second year. Your money grows faster when using compound interest. This is critical to understand because it affects all investments, especially a retirement investment. The earlier you start investing, the more interest you can earn on compound interest year after year. The same concept can be applied to debt. Your initial unpaid balance on a loan will grow very quickly under compound interest. The most beneficial financial transaction for you would be to pay down your loans very quickly but to allow your savings enough time to grow.
To manually calculate compounding interest you need to recall the formula. Granted, there are calculators that do that for you very quickly, but it is refreshing to know you understand what the numbers and the letters mean:
The formula for annual compound interest, including principal sum, is:
A = P (1 + r/n) (nt)
Where:
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per year
t = the number of years the money is invested or borrowed for
2. Time value of money
The second concept to know is the time value of money (TVM). It is the idea that money available at the present time is worth more than the same amount in the future; this is due to its potential earning capacity.
This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. It is also referred to as present discounted value.
The formula for TVM is:
FV = PV x (1 + (i / n)) ^ (n x t)
Where:
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of compounding periods per year
t = number of years
Again, there are calculators and applications that can help you determine the present and future value of money, but it is critical you understand what the letters mean and how to use these concepts to manage your money. In order to learn more, please refer our module on Time Value of Money in this series.
Practice
Now that you know all about compound interest and the time value of money, think of paying it forward and discuss these concepts with a friend or a family member.
To review the full module on Saving & investing, click here.