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

1

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

n

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

1

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).