The first steps toward understanding the relationship between the value of dollars today and that of dollars in the future is by looking at how funds invested will grow over time. This understanding will allow one to answer such questions as; how much should be invested today to produce a specified future sum of money?
Time Value of Money
In most cases, borrowing money is not free, unless it is a fiver for lunch from a friend. Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount borrowed per a period of time, usually one year. The current market rates are composed of three items. The Real Rate of Interest is what compensates lenders for postponing their own spending during the term of the loan. An Inflation Premium is added to offset the possibility that inflation may eat into the value of the money during the term of the loan. In addition, various Risk Premiums are added to compensate the lender for risky loans such as unsecured loans made to borrowers with questionable credit ratings or loans that the lender may not be able to easily resell. The first two components of the interest rate listed above, the real rate of interest and an inflation premium, together are referred to as the nominal risk-free rate. In the United States, the nominal risk-free rate is estimated by the rate of US Treasury bills. Simple interest is calculated on the original principal only. Interest from prior periods is not used in calculations for the following periods. Simple interest is normally used for a single period loan of less than a year, such as 30 or 60 days loans. The formula is: Simple Interest = p * i * n
p = principal (original amount borrowed or loaned)
i = interest rate for one period
n = number of periods
Compound interest is calculated each period on the original principal and all interest accumulated during past periods. The interest rate normally is stated as a yearly rate....