Time Value of Money
Two types of interest rates are simple and compound interest rates. With a simple interest rate the money invested into an account earns interest based on the initial deposit. When a compound interest is applied to the account then the money can earn interest on itself, including the money earned by the interest. Interest rates are always an important factor in financial decisions but even more so if a person is trying to yield a high rate of return. The higher the interest rate of the account the better and preferably a compound rate if possible to earn more. (McGraw, 2003)
Present Value is the amount an investment is worth in today’s dollars. On the day you invest $500 into an account the value is $500. If you loan this money to someone who does not have to pay it back for 5 years, is the value going to be the same? This is part of future value. Future value represents the principle plus the accumulated interest of the investment. Future value is the amount to which an investment will grow after earning interest (McGraw, 2003). If your $500 will depreciate over the next five years the lender wants to be sure to add a sufficient interest rate so that when the money is returned it still holds the same value.
Opportunity cost can be defined as: the cost of doing an activity instead of doing something else – applied to the time involved in unproductive activities (Bristol, 2006). The cost of capital is the minimum acceptable rate of return for capital investments (McGraw, 2003). In other words is the risk of investment worth the rate of return offered on the money being invested? Is the money better invested into another venture? Twenty years ago a large investment in Microsoft would have yielded very high returns, though at the time some may have considered it very risky. Today investing in a brand new yo-yo making company may not offer the same return as investing that money into a high interest account or UPS stock options.
An annuity is a series of equal payments or deposits made over equal time periods (McGraw, 2003). Annuities can be made weekly, monthly, quarterly, yearly, or over any equal time period. Everyone has annuities to pay of some kind, an internet bill due the 13th of each month, a car payment due the 10th, or condo fees due yearly. While some may say that time does not affect annuities as they are a series of equal payments those payments were decided based on a future return. A bank may loan a person $10,000 to purchase a car; however, they are going to charge significant interest on it. The interest is going to cover the future value of the money as well as some profit for the bank.
The rule of 72 is a shortcut to finding out how long it takes for an investment to double. To use this one would take the interest rate of the investment and divide it by 72. As the example from the reading shows if you invest $10,000 at an interest rate of 10% it will take 7.2 years for it to double to $20,000. Simple checks like these are helpful in saving time and still prove to be accurate.
Understanding how money can increase or decrease in value over time is critical in dealing with investments. When applying for a loan an individual will want a lower interest rate to prevent over paying in the long run, when investing money into an account such as a long term CD a person will want a high compound interest rate. There are many factors to consider when working with finances and the factors that favor you best will vary based on which side of the investment you are on. For these reasons it is important to understand the aspects involved with the time value of money.
