Future Value of Money
For investors, knowing the future and present values of investment options can help determine investment decisions. Investors balance investment earning potential against the expected inflation rate (over the investment period) as well as the potential return other investments might bring. Investors balance risk with the potential reward as well. Some investments, such as government bonds, produce low returns, perhaps even lower than the rate of inflation, but they are very safe investments because they have low risk. Buying stock in an individual company, however, has the potential for a much higher return but comes at the price of much more risk. This risk may include the possibility of losing the investment in part or in full. Generally, the riskier the investment, the higher the return expected. The risk must be worthwhile to the investor.The rule of 72 is a mathematical shortcut that investors can use when calculating the potential return on an investment. The rule is a simple formula in which 72 is divided by the compound annual interest rate. This calculation helps determine approximately how long it will take for an initial investment to double. For example, if Mary Nelson invests $1,000 earning 12 percent interest each year compounding annually, it will take approximately six years, , for Mary to double the initial investment from $1,000 to $2,000.
Impact of Compound Interest
Future and Present Value of Money and Investment Decision-Making
For consumers, time value of money considerations are relevant with regard to both investing and borrowing. Usury, or predatory lending, is the act of lending money to a borrower at an illegal and excessively high rate of interest. Lenders who make such loans are often referred to as loan sharks or payday lenders. Many states have laws limiting how high the interest rate on a loan can be. States also require lenders to state loans in terms of the annual percentage rate (APR) so borrowers know the cost of taking out a loan, but if the loan does not compound annually, using APR can misstate the actual cost of borrowing the funds. Thus, the effective annual rate is used to determine the annual effective yield of a loan. The effective annual rate (EAR) is a measurement of the annual compound interest rate when compounding occurs more than once a year.
For example, if Mary Nelson is carrying a balance on a credit card of $1,000 and the APR on the credit card is 24 percent compounded monthly, the balance owed of $1,000 on January 1 would be $1,020 on February 1 after the 2 percent monthly interest rate is added (). Then, if Mary does not pay the credit card off right away, the following month more interest will accrue, not just on the initial debt but on the unpaid interest charges from prior months as well. Thus, the EAR will always be higher than the APR if the interest compounds more often than annually. Consumers need to take this into consideration if they are carrying any debts.
For many investors, if the EAR is high enough it may make more sense to pay down debt rather than investing in a new opportunity. It would depend on what the expected return of that investment might be. Paying off a debt at a high rate that compounds frequently does provide a guaranteed return on investment equal to the rate applied to the carried debt.
A small business may make a similar calculation when it comes to investing in the business. For example, Cogs Inc. wants to spend $25,000 to replace an old machine. It can either borrow the money and pay the accruing debt off over time or save enough from its revenues each month and invest that in purchasing the new machine outright. A future value calculator can tell the company how much should be saved each month over what number of months in order to save $25,000. Cogs Inc. would then compare the cost to its borrowing costs and determine the best financial decision.