unit 4: cost of money
TRANSCRIPT
Unit 4: Cost of Money
The Role of Interest RatesMr. Elsesser
Introduction toFinancial Management
What is an Interest Rate? Interest rates play a key role in borrowing, taking loans, and receiving earnings on your savings/investments. Interest Rates:
A rate that is charged or paid for the use of money. Expressed as an annual percentage of the principal. Principal:
The amount of money that you invest or borrow. When you borrow money:
Interest rates are the cost of borrowing. When you invest or save money:
Interest rates are your earnings for allowing corporations or financial institutions to use your money.
Annual Percentage Rate (APR)Another name for interest rates is APR. YOU MUST KNOW THESE WHEN:
Trying to decide where you will get the best deal on a credit card, loan, or return on investment.
It is the law for credit card companies and loan borrowers to give customers a full understanding of the actual rates applicable to their agreements. When you invest or save money:
Interest Rates and The FEDThe Federal Reserve Bank plays a large role in influencing interest rates, especially to stimulate the economy. When Interest Rates are LOWERED:
Cheaper Borrowing Costs Consumers will take out loans to finance greater
spending/investments. Incentive to Save Money Decreases:
Consumers will want to spend as opposed to hold onto their money.
Lower Interest Payments on mortgages, cars, etc.
Prices of Assets Increase Large assets like home price will increase—as will
the rise of wealth and consumer confidence.
Interest Rates and The FEDThe Federal Reserve Bank plays a large role in influencing interest rates, especially to stimulate the economy. When Interest Rates are RAISED:
Borrowing Becomes More Expensive People will have less disposable income as more
money will be paid in interest. Incentive to Save Money Increases:
Consumers will want their money earning interest in savings accounts as opposed to spending
Spending and Consumption Decreases Across Economy
Prices of Assets can Decrease Consumer Confidence Decreases
Time Value of MoneyTIME VALUE OF MONEY:
Savings accounts and other investments pay interest on the money you deposit, which increases the amount of money in your account over time.
Amount of earnings growth depends on the combination of time, money, and rate of return (interest).
Time
Money
Time, Money and the Rate of InterestThe more time you have to save the more money you will have at the end of the time period.
The more money you have to save the more money you will have at the end of the time period.
InterestThe higher the rate of interest you can earn, the more money you will have at the end of the time period.
How Interest is EarnedThere are 2 ways you can receive interest payments:
1. Simple Interest: A quick method to calculating the interest
charge on a loan or payment on a deposit. The charge/payment is always based on the
original principal. Mainly used for short-term loans Simple Interest Formula: Interest = PRINCIPAL x RATE x TIME
Principal = original amount of deposit/loan Rate = Interest Rate of Return/APR (Annual
Percentage Rate Time = Period of time
Usually measured in years
Simple Interest Example If you had $100 in a savings account that paid 6% simple
interest, during the first year you would earn $6 in interest.
Steps: 1. Write the formula:
I=PxRxT 2. Identify your values:
P=$100, R= 0.06, T=1 3. Plug in your values:
$100 x 0.06 x 1 = $6 At the end of two years you would have
earned $12. The account would continue to grow at a rate of
$6 per year, despite the accumulated interest.
NEFE High School Financial Planning ProgramUnit Three – Investing: Making Money Work for You
Investing Annually to Achieve a GoalValue of $20 1 Year 2 Years 4 Years 6 Years
4%
5%
6%
8%
10%
$20.80
$21.00
$21.20
$21.60
$22.00
$21.63
$22.05
$22.47
$23.33
$24.20
$23.40
$24.31
$25.25
$27.21
$29.28
$25.31
$26.80
$28.37
$31.74
$35.43
Building….
How Interest is EarnedThere are 2 ways you can receive interest payments:
2. Compounded Interest: Interest is paid or received on the original amount
of the loan or deposit, plus any interest earned. Compounded Interest Formula:
Amount = PRINCIPAL x (1 + I)
Amount = original amount in account Principal = original amount of deposit Interest = Interest Rate of Return expressed as
decimal N = Number of years compounded
1=1yr
To Understand the concept, you need a scientific
calculator to do the math
n
Compounded Interest Example If you had $100 in a savings account that paid 6% interest compounded
annually, the first year you would earn $6.36 in interest. Steps:
1. Write the formula: Amount = PRINCIPAL x (1 + I)
2. Identify your values: P=$100, I= 0.06, T=1
3. Plug in your values: $100 x (1+.06) = $106 Using simple interest add your amount to new principal = $100+$6 =
$106 With compounded interest, the second year you would earn
$6.36 in interest. Here is the calculation using simple interest: $106 x 0.06 x 1 = $6.36 $106 + $6.36 = $112.36-- new amount in account USING COMPOUND INTEREST FORMULA:
100x(1+.06)^2 = $112.36
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Another Compounded Interest Example
Compounding – the idea of earning interest on interest
Assume you have $100 in an account earning 10% interest per year…A the end of that one year, you have $110 in your account….In year two your account earns 10% - How much do you have at the end of the second year?
Example AnswerCompounding –
the idea of earning interest on interestAnswer = $121.00
USING SIMPLE INTEREST: 100 x 10% x 1 = $10 (100 + 10) = 110 x 10% x 1 = $11 yr2
USING COMPOUND INTERESTAmount = Principal x (1 +I)100x(1+.1)^2 = $121.00
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NEFE High School Financial Planning ProgramUnit Three – Investing: Making Money Work for You
Investing a $10,000 Lump Sum
11%
10%
9%
8%
7%
6%
5%
12%
InterestRate
5Years
20Years
15Years
10Years
$12,763
$17,623
$16,851
$16,105
$15,386
$14,693
$14,026
$13,382
$16,289
$31,058
$28,394
$25,937
$23,674
$21,589
$19,672
$17,908
$20,789
$54,736
$47,846
$41,772
$36,425
$31,722
$27,590
$23,966
$26,533
$96,463
$80,623
$67,275
$56,044
$46,610
$38,697
$32.071
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NEFE High School Financial Planning ProgramUnit Three – Investing: Making Money Work for You
Investing $1,000 Annually
11%
10%
9%
8%
7%
6%
5%
12%
InterestRate
5Years
20Years
15Years
10Years
$5,526
$6,353
$6,228
$6,105
$5,985
$5,867
$5,751
$5,637
$12,578
$17,549
$16,722
$15,937
$15,193
$14,487
$13,816
$13,181
$21,579
$37,280
$34,405
$31,772
$29,361
$27,152
$25,129
$23,276
$33,066
$72,052
$64,203
$57,275
$51,160
$45,762
$40,995
$36,786
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The Rule of 72To determine how long it will take to double your money, you need to use the RULE OF 72::
72Interest Rate
= Years Needed toDouble Investment
72 Interest RateRequired=
Years Needed toDouble Investment
The Rule of 72Example #1:
Assuming you can earn 6% on your money, how long will it take $100 to grow to $200?
72Interest Rate
=Years Needed toDouble Investment
726% = 12 years
The Rule of 72Example #2:Now, let’s say you have a set time period in mind to double your investment. If you have $200 today and need $400 in 8 years, what interest rate do you need to earn?
728 years= 9%
72 Interest RateRequired=
Years Needed toDouble Investment
Key to InvestingIt’s all about:
RISK AND RETURN: The more risk you take with
your money, the potential you will have for a higher return.
The less risk, the less of a chance for a greater return
RATE OF RETURN: How fast your money grows.
Impact of Higher Returns on Savings and Investments
Interest Rate
3%
24 Yrs.
$800
4%
6%
8%
12%
6 Yrs. 9 Yrs. 12 Yrs. 18 Yrs.
$400
$400
$400
$200
$200
$200
$200
$200
Examining Compounded Interest
The more frequently your money is compounded the better your return on savings:
Therefore, it is better to choose an account that will pay you:
Daily over Weekly Weekly over Monthly Monthly over Quarterly
INFLATIONINFLATION:
The rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling.
The FED tries to monitor and control the rate of inflation in a attempt to keep the excessive growth of prices down.
Ex: If the inflation rate is 2%, than a $1 pack of gum will cost $1.02 next year.
INFLATION Impact of Inflation on:
Interest Rates: Increase/Decrease has a direct relationship on
the cost of borrowing. Purchasing/Buying Power:
Increase/Decrease has a direct relationship on the amount of purchasing or buying power.
Who benefits most from inflation? Borrowers and producers
Who benefits least from inflation? Lenders/savers (APR is inflated), lower-
income/fixed income families, individuals/businesses (rushed transactions).