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Table of Contents
Interest (An Introduction) ......................................................................................................................................... 6
Money is Not Free to Borrow ........................................................................................................................................... 6
How Much does it Cost to Borrow Money? .................................................................................................................... 6
As a percent (per year) of the amount borrowed ....................................................................................................... 6
Example: Borrow $1,000 from the Bank .................................................................................................................... 6
This is the idea of Interest ... paying for the use of the money. ................................................................................. 6
Words ................................................................................................................................................................................. 7
More Than One Year ....................................................................................................................................................... 7
Simple Interest............................................................................................................................................................... 7
Example: Alex borrows $1,000 for 5 Years, at 10% simple interest: ....................................................................... 7
Example: Jan borrowed $3,000 for 4 Years at 5% interest rate, how much interest is that? ............................... 8
Compound Interest ....................................................................................................................................................... 8
What is Year 0? ............................................................................................................................................................. 9
Why Borrow? .................................................................................................................................................................... 9
Example: Chicken Business ....................................................................................................................................... 10
Investment ....................................................................................................................................................................... 10
Less Than One Year ... ................................................................................................................................................... 11
It is called Interest
In this case the "Interest" is $100, and the "Interest Rate" is 10% (but people often say "10% Interest" without
saying "Rate")
Of course, Alex will have to pay back the original $1,000 after one year, so this is what happens:
This is the idea of Interest ... paying for the use of the money.
Note: I am showing a full year loan, but banks often want you to pay back the loan in
small monthly amounts, and they also charge extra fees too!
Words
There are special words used when borrowing money, as shown here:
The important part of the word "Interest" is Inter- meaning between (we see inter- in words like interior and
interval), because the interest happens between the start and end of the loan.
Simple Interest
If the bank charges "Simple Interest" then Alex just pays another 10% for the extra year.
That is how simple interest works ... pay the same amount of interest every year.
I = Prt
where
I = interest
P = amount borrowed (called "Principal")
r = interest rate
t = time
Like this:
Example: Jan borrowed $3,000 for 4 Years at 5% interest rate, how much interest is that?
I = Prt
I = $3,000 × 5% × 4 years
I = 3000 × 0.05 × 4
I = $600
Compound Interest
But the bank says "If you paid me everything back after one year, and then I loaned it to you again ... I would be
loaning you $1,100 for the second year!"
And Alex pays $110 interest in the second year, not just $100.
This may seem unfair ... but imagine YOU lend the money to Alex. After a year you think "Alex owes me
$1,100 now, and is still using my money, I should get more interest!"
With compounding we work out the interest for the first period, add it the total, and then calculate the interest
for the next period, and so on ..., like this:
It is like paying interest on interest: after a year Alex owed $100 interest, the Bank thinks of that as another loan
and charges interest on it, too.
After a few years it can get really large. This is what happens on a 5 Year Loan:
And the Interest for the last year was $146.41 ... it sure grew quickly!
What is Year 0?
Year 0 is the year that starts with the "Birth" of the Loan, and ends just before the 1st Birthday.
Just like when a baby is born its age is zero, and will not be 1 year old until the first birthday.
So the start of Year 1 is the "1st Birthday". And the start of Year 5 is exactly when the loan is 5 years old.
In Summary:
To calculate compound interest, work out the interest for the first period, add it on, and then calculate the
interest for the next period, etc.
Why Borrow?
Well ... you may want to buy something you like. Paying it back will end up costing you more though.
But a business may be able to use the money to make even more money.
Example: Chicken Business
You borrow $1,000 to start a chicken business (to buy chicks, chicken food and so on).
A year later you sell all the grown chickens for $1,200.
You pay back the bank $1,100 (the original $1,000 plus 10% interest) and you are left with $100 profit.
But be careful! What if you only sold the chickens for $800? ... the bank still wants $1,100 and you end up with
a $300 loss.
Investment
Compound Interest can work for you!
Investment is when you put money where it can grow, such as a bank, or a business.
If you invest your money at a good interest rate it can grow very nicely.
An investment at 15% is not likely to be safe (see Investing introduction) ... but it does show us the power of
compounding.
For simple interest: work out the interest for one period, and multiply by the number of periods.
For compound interest: work out the interest for the first period, add it on and then calculate the interest
for the next period, etc.
Compound Interest
You may wish to read Introduction to Interest first
With Compound Interest, you work out the interest for the first period, add it to the total, and then calculate the
interest for the next period, and so on ..., like this:
Note: the Interest Rate was turned into a decimal by dividing by 100:
Read Percentages to learn more, but in practice just move the decimal point 2 places, like these examples:
But it is easier to write down a series of multiplies using Exponents (or Powers) like this:
This does all the calculations in the top table in one go.
The Formula
We have been using a real example, but let's be more general by using letters instead of numbers, like this:
(Can you see it is the same? Just with PV = $1,000, r = 0.10, n = 5, and FV = $1,610.51)
FV = PV × (1+r)n
Examples
... and what if the loan was for 5 years, but the interest rate was only 6%? Here:
Did you see how we just put the
6% into its place like this:
... and what if the loan was for 20 years at 8%? ... you work it out!
In other words, you know a Future Value, and want to know a Present Value.
We know that multiplying a Present Value (PV) by (1+r)n gives us the Future Value (FV), so we can go
backwards by dividing, like this:
PV = FV / (1+r)n
In other words, $1,241.84 will grow to $2,000 if you invest it at 10% for 5 years.
Another Example: How much do you need to invest now, to get $10,000 in 10 years at 8% interest rate?
Compounding Periods
Compound Interest is not always calculated per year, it could be per month, per day, etc. But if it is not per
year it should say so!
Example: you take out a $1,000 loan for 12 months and it says "1% per month", how much do you pay back?
Just use the Future Value formula with "n" being the number of months:
Example, 6% interest with "monthly compounding" does not mean 6% per month, it means 0.5% per month
(6% divided by 12 months), and is worked out like this:
This is equal to a 6.168% ($1,000 grew to $1,061.68) for the whole year.
APR
Because it is easy for loan ads to be confusing (sometimes on purpose!), the "APR" is often
used.
APR means "Annual Percentage Rate" ... it shows how much you will actually be paying
for the year (including compounding, fees, etc).
This ad looks like 6.25%, but is really 6.335%
Example 1: "1% per month" actually works out to be 12.683% APR (if no fees).
And:
Example 2: "6% interest with monthly compounding" works out to be 6.168% APR (if no fees).
Break Time!
So far we have looked at using (1+r)n to go from a Present Value (PV) to a Future Value (FV) and back again,
plus some of the tricky things that can happen to a loan.
Now is a good time to have a break before we look at two more topics:
How to work out the Interest Rate if you know PV, FV and the Number of Periods.
How to work out the Number of Periods if you know PV, FV and the Interest Rate
r = ( FV / PV )1/n - 1
Note: the little "1/n" is a Fractional Exponent, first calculate 1/n, then use that as the
exponent on your calculator.
So you need 14.87% interest rate to turn $1,000 into $2,000 in 5 years.
Another Example: What interest rate do you need to turn $1,000 into $5,000 in 20 Years?
Example: you want to know how many periods it will take to turn $1,000 into $2,000 at 10% interest.
This is the formula (note: it uses the natural logarithm function ln):
You could also use log, just don't mix the two.
Magic! It will need 7.27 years to turn $1,000 into $2,000 at 10% interest.
Another Example: How many years to turn $1,000 into $10,000 at 5% interest?
Calculator
I also made a Compound Interest Calculator that uses these formulas.
Summary
The basic formula for Compound Interest is:
FV = Future Value,
PV = Present Value,
r = Interest Rate (as a decimal value), and
n = Number of Periods
And by rearranging that formula (see Compound Interest Formula Derivation) we can find any value when we
know the other three:
Annuities
So far we have talked about what happens to a value as time goes by ... but what if you have a series of values,
like regular loan payments or yearly investments? That is covered in Annuities, coming soon.
Compound Interest: Periodic Compounding
You may like to read about Compound Interest first.
You can skip straight down to Periodic Compounding.
In fact we can go from the Start to Year 5 if we multiply 5 times using Exponents (or Powers):
The Formula
This is the formula for Compound Interest (like above but using letters instead of numbers):
Number of Periods n = 5
PV × (1 + r)n = FV
$1,000 × (1 + 0.10)5 = FV
$1,000 × 1.105 = $1,610.51
Now we can choose different values, such as an interest rate of 6%:
Number of Periods n = 5
PV × (1 + r)n = FV
$1,000 × (1 + 0.06)5 = FV
$1,000 × 1.065 = $1,338.23
... but it is calculated more than once within the year, with the interest added each time ...
but each time it is compounded (meaning the interest is added to the total):
Example
10% The Nominal Rate (the rate they mention)
When interest is compounded within the year, the Effective Annual Rate is higher than the rate mentioned.
How much higher depends on the interest rate, and how many times it is compounded within the year.
Working It Out
Let's come up with a formula to work out the Effective Annual Rate if we know:
Our task is to take an interest rate (like 10%) and chop it up into "n" periods, compounding each time.
From the Compound Interest formula (shown above) we can compound "n" periods using
FV = PV (1+r)n
But the interest rate won't be "r", because it has to be chopped into "n" periods like this:
r/n
FV = PV (1+(r/n))n
That worked! But we want to know what the new interest rate is, we don't want the dollar values in there, so
let's remove them:
That has the interest rate in there (0.1025 = 10.25%), but we should subtract the extra 1:
= (1+(0.06/12))12 − 1
So:
FV = PV (1+(0.07/4))4
FV = PV (1+(0.07/4))4
FV = PV (1.0719...)
So remember:
Table of Values
Here are some example values. Notice that compounding has a very small effect when the interest rate is small,
but a large effect for high interest rates.
Continuously?
Yes, if you have smaller and smaller periods (hourly, minutely, etc) you eventually reach a limit, and we even
Example:
Using It
Now that you can calculate the Effective Annual Rate (for specific periods, or continuous), we can use it in any
normal compound interest calculations.
That is 8.329%
FV = PV × (1+r)n
FV = $10,000 × (1+0.08329)2
Conclusion
Effective Annual Rate = (1+(r/n))n − 1
Where:
With Compound Interest we work out the interest for the first period, add it to the total, and then calculate the
interest for the next period, and so on ..., like this:
Make A Formula
Let's look at the first year to begin with:
(Note: the Interest Rate was turned into a decimal by dividing by 100: 10% = 10/100 = 0.10, read Percentages
to learn more.)
But it is easier to write down a series of multiplies using Exponents (or Powers) like this:
The Formula
We have been using a real example, but let us make it more general by using letters instead of numbers, like
this:
(Can you see it is the same? Just with PV = $1,000, r = 0.10, n = 5, and FV = $1,610.51)
Examples
... and what if the loan was for 5 years, but the interest rate was only 6%? Here:
FV = PV (1+r)n
FV = Future Value,
PV = Present Value,
r = Interest Rate (as a decimal value), and
n = Number of Periods
With that we can work out the Future Value FV when we know the Present Value PV, the Interest Rate r and
Number of Periods n
And we can rearrange that formula to find FV, the Interest Rate or the Number of Periods when we know the
other three.
Find the Future Value when we know a Present Value, the Interest
FV = PV (1+r)n
Rate and number of Periods.
Find the Present Value when we know a Future Value, the Interest
PV = FV / (1+r)n
Rate and number of Periods.
Find the Interest Rate when we know the Present Value, Future Value
r = ( FV / PV )1/n - 1
and number of Periods.
Find the number of Periods when we know the Present Value, Future
n = ln(FV / PV) ln(1 + r)
Value and Interest Rate
In other words, we know a Future Value, and want to know a Present Value.
We can just rearrange the formula to suit ... dividing both sides by (1+r)n to give us:
Example (continued):
(Note: to understand the step "take nth root" please read Fractional Exponents)
r = ( FV / PV )1/n − 1
Now we have the formula, it is just a matter of "plugging in" the values to get the result:
Example (continued):
Another Example: What interest rate do you need to turn $1,000 into $5,000 in 20 Years?
And 0.0838 as a percentage is 8.38%. So 8.38% will turn $1,000 into $5,000 in 20 Years.
Working Out How Many Periods
Example: Sam can only get a 10% interest rate. How many years will it take Sam to get
$2,000?
When we want to know how many periods it takes to turn $1,000 into $2,000 at 10% interest, we can rearrange
the basic formula.
(Note: to understand the step "use logarithms" please read Working with Exponents and Logarithms).
Example (continued):
Magic! It will need 7.27 years to turn $1,000 into $2,000 at 10% interest.
Another Example: How many years to turn $1,000 into $10,000 at 5% interest?
Conclusion
Knowing how the formulas are derived and used makes it easier for you to remember them, and to use them in
different situations.
Present Value (PV)
Money now is more valuable than money later on.
You could run a business, or buy something now and sell it later for more, or simply put the money in the bank
to earn interest.
Present Value
So $1,000 now is the same as $1,100 next year (at 10% interest).
Because we could turn $1,000 into $1,100 (if we could earn 10% interest).
Now let us extend this idea further into the future ...
So:
Easier Calculation
But instead of "adding 10%" to each year it is easier to multiply by 1.10 (explained at Compound Interest):
Example: Sam promises you $500 next year, what is the Present Value?
So $500 next year is $500 ÷ 1.10 = $454.55 now (to nearest cent).
Example: Alex promises you $900 in 3 years, what is the Present Value?
To take a future payment backwards three years divide by 1.10 three times
As a formula it is:
PV = FV / (1+r)n
PV is Present Value
FV is Future Value
r is the interest rate (as a decimal, so 0.10, not 10%)
n is the number of years
Example: (continued)
PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3 = $900 / 1.103 = $676.18 (to nearest cent).
For example 1.106 is quicker than 1.10 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10
Example: What is $570 next year worth now, at an interest Rate of 10% ?
Example: What is $570 next year worth now, at an interest Rate of 15% ?
Example: What is $570 in 3 years time worth now, at an interest Rate of 10% ?
Example: You are promised $800 in 10 years time. What is its Present Value at an interest
rate of 6% ?
You could run a business, or buy something now and sell it later for more, or simply put the money in the bank
to earn interest.
Example: Let us say you can get 10% interest on your money.
So $1,000 now is the same as $1,100 next year (at 10% interest):
Because $1,000 can become $1,100 in one year (at 10% interest).
If you understand Present Value, you can skip straight to Net Present Value.
Now let us extend this idea further into the future ...
In fact all those amounts are the same (considering when they occur and the 10% interest).
Easier Calculation
But instead of "adding 10%" to each year it is easier to multiply by 1.10 (explained at Compound Interest):
Example: Sam promises you $500 next year, what is the Present Value?
So $500 next year is $500 ÷ 1.10 = $454.55 now (to nearest cent).
Example: Alex promises you $900 in 3 years, what is the Present Value?
To take a future payment backwards three years divide by 1.10 three times
Example: (continued)
And we have in fact just used the formula for Present Value:
PV = FV / (1+r)n
PV is Present Value
FV is Future Value
r is the interest rate (as a decimal, so 0.10, not 10%)
n is the number of years
Example: (continued)
PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3 = $900 / 1.103 = $676.18 (to nearest cent).
For example 1.106 is quicker than 1.10 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10
Example: A friend needs $500 now, and will pay you back $570 in a year. Is that a good
investment when you can get 10% elsewhere?
(In other words it is $18.18 better than a 10% investment, in today's money.)
A Net Present Value (NPV) that is positive is good (and negative is bad).
It is a bad investment. But only because you are demanding it earn 15% (maybe you can get 15% somewhere
else at similar risk).
Side Note: the interest rate that makes the NPV zero (in the previous example it is about 14%) is called the
Internal Rate of Return.
Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd
year. Use 10% Interest Rate.
Let us work year by year (remembering to subtract what you pay out):
Now: PV = -$2,000
Year 1: PV = $100 / 1.10 = $90.91
Year 2: PV = $100 / 1.102 = $82.64
Year 3: PV = $100 / 1.103 = $75.13
Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29
Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97
Now: PV = -$2,000
Year 1: PV = $100 / 1.06 = $94.34
Year 2: PV = $100 / 1.062 = $89.00
Year 3: PV = $100 / 1.063 = $83.96
Year 3 (final payment): PV = $2,500 / 1.063 = $2,099.05
Adding those up gets: NPV = -$2,000 + $94.34 + $89.00 + $83.96 + $2,099.05 = $366.35
Because the interest rate is like the team you are playing against, play an easy
team (like a 6% interest rate) and you look good, a tougher team (like a 10%
interest) and you don't look so good!
You can actually use the interest rate as a "test" or "hurdle" for your investments: demand that an investment
have a positive NPV with, say, 6% interest.
So there you have it: work out the PV (Present Value) of each item, then total them up to get the NPV (Net
Present Value), being careful to subtract amounts that go out and add amounts that come in.
And a final note: when comparing investments by NPV, make sure to use the same interest rate for each.
Internal Rate of Return (IRR)
The Internal Rate of Return is a good way of judging an investment. The bigger the better!
The Internal Rate of Return is the interest rate that makes the Net Present Value zero.
It is an Interest Rate.
You find it by first guessing what it might be (say 10%), then work out the Net Present Value (I will show
you how).
Then keep guessing (maybe 8%? 9%?) and calculating until you get a Net Present Value of zero.
Sam estimates all the costs and earnings for the next 2 years, and calculates the Net Present Value:
But the Net Present Value should be zero, so Sam tries 8% interest:
Now it's negative! So Sam tries once more, but with 7% interest:
So the key to the whole thing is ... calculating the Net Present Value!
But before adding it all up you should calculate the time value of money.
Example: Let us say you can get 10% interest on your money.
Present Value
So $1,000 now is the same as $1,100 next year (at 10% interest).
Present Value has a detailed explanation, but let's skip straight to the formula:
PV = FV / (1+r)n
PV is Present Value
FV is Future Value
r is the interest rate (as a decimal, so 0.10, not 10%)
n is the number of years
Example: Alex promises you $900 in 3 years, what is the Present Value (using a 10% interest
rate)?
PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3
PV = $900 / 1.103
PV = $676.18 (to nearest cent)
Notice that $676.18 is a lot less than $900.
PV = FV / (1+r)n
PV = $900 / (1 + 0.06)3
PV = $900 / 1.063
PV = $755.66 (to nearest cent)
When we only get 6% interest, then $755.66 now is as valuable as $900 in 3 years.
For each amount (either coming in, or going out) work out its Present Value, then:
Like this:
Example: You invest $500 now, and get back $570 next year. Use an Interest Rate of 10% to
work out the NPV.
Example: Same investment, but work out the NPV using an Interest Rate of 15%
Now it gets interesting ... what Interest Rate can make the NPV exactly zero? Let's try 14%:
Exactly zero!
And we have discovered the Internal Rate of Return ... it is 14% for that investment.
And that "guess and check" method is the common way to find it (though in that simple case it could have been
worked out directly).
Now: PV = -$2,000
Year 1: PV = $100 / 1.10 = $90.91
Year 2: PV = $100 / 1.102 = $82.64
Year 3: PV = $100 / 1.103 = $75.13
Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29
Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97
Now: PV = -$2,000
Year 1: PV = $100 / 1.12 = $89.29
Year 2: PV = $100 / 1.122 = $79.72
Year 3: PV = $100 / 1.123 = $71.18
Year 3 (final payment): PV = $2,500 / 1.123 = $1,779.45
Adding those up gets: NPV = -$2,000 + $89.29 + $79.72 + $71.18 + $1,779.45 = $19.64
Now: PV = -$2,000
Year 1: PV = $100 / 1.124 = $88.97
Year 2: PV = $100 / 1.1242 = $79.15
Year 3: PV = $100 / 1.1243 = $70.42
Year 3 (final payment): PV = $2,500 / 1.1243 = $1,760.52
Adding those up gets: NPV = -$2,000 + $88.97 + $79.15 + $70.42 + $1,760.52 = -$0.94
That is good enough! Let us stop there and say the Internal Rate of Return is 12.4%
In a way it is saying "this investment could earn 12.4%" (assuming it all goes according to plan!).
First of all, the IRR should be higher than the cost of funds. If it costs you 8% to borrow money, then an IRR of
only 6% is not good enough!
Example: instead of investing $2,000 like above, you could also invest 3 yearly sums of $1,000 to gain $4,000
in the 4th year ... should you do that instead?
I did this one in a spreadsheet, and found that 10% was pretty close:
And so the other investment (where the IRR was 12.4%) is better.
Doing your calculations in a spreadsheet is great as you can easily change the interest rate until the NPV is zero.
You also get to see the influence of all the values, and how sensitive the results are to changes (which is called
"sensitivity analysis").
Investing (Introduction)
Investing:
Investing is where you use money to (hopefully) make more money.
You can buy something valuable, such as an antique or a rare coin, and sell it later.
They can pay dividends (regular payments to you based on their profit).
AND you can sell the stock later, maybe for a higher price.
You can ... well there are LOTS of choices for investing money.
But how do you tell which are good and bad investments?
Often the investments that promise the biggest profits are also the ones with the biggest risk.
Example: banks pay low interest, but they are also low risk.
And that wonderful investment in a gold mine that promises 30% profit? It may work out well, or it may not!
And remember: risk is risky! The more risk you take, the higher the chance that you will end up losing.
How can you tell how risky an investment is? Ah! That is the million dollar question.
Do research! Find out all you can about how previous investments have worked out. Think about the future of
the investment (things that are good now can turn bad), and also ... can you trust the people involved?
Before you hand over any money, stop being excited by the idea of profits and think what might go wrong. A
wise friend once said it was the investments he didn't make that led to him being rich.
Comparing Investments
OK, you have some possible investments. The risks are about the same. How to tell which is best?
The basic idea is to add up all the money you receive, and subtract all the money you spend.
But you also need to think when you spend or receive the money.
In fact, at 10% interest, $200 now is the same as $220 next year!
So money is not as valuable in the future, so we reduce the value of future payments.
Example: Two investments that both cost $200: one pays $220 next year, the other pays $230
in 2 years time.
The first investment pays $220 in 1 year. Reinvesting that $220 for another year might get you more than $230
by the 2nd year.
There are many ways to compare investments, but two of the most popular ways are:
Example: you run a Bakery, and want to improve its income. You could:
You estimate the costs and benefits, and then calculate the "Internal Rate of Return" of each to be:
So "Move" is best.
Move is more risky: will you really get more customers? What about the customers you lose? What if
someone opens a bakery at your old location, they will take business away from you.
Renovate is much less risky, you know it will save money for your present operation.
If the Move goes bad you could lose your whole business.
So choose carefully!
Diversify!
To "diversify" means to have different types of investments ("diverse" means "different").
But (hopefully) your money in the bank or with government bonds is still OK.
There is an old saying: don't put all your eggs in one basket.
one-third of your money into cash investments like a bank account or bonds,
one-third into property, and
one-third into the stock market.
But that is only a guide, you should decide for yourself what the best "spread of investments" is (and it can
change, depending on how the economy is going).
You can plan your whole year this way, and have money left over to save for big things like a new car, house,
holidays, etc.
Let's start!
List the things you need and what you spend on them per month.
Your Turn: List all your expenses for last month. If you are still at school, ask to do the family budget.
Type the numbers into a spreadsheet (like Open Office Calc or Microsoft Excel).
Now list your wants (not needs) and how much you'd like to spend on them per month.
Example: Sam has these "wants":
And then find out what is left over from what you earned.
Great! Sam has $435 left over. It is important to have some left over here, as we will need it for other things
Your Turn: Complete your list of wants and needs, and compare it to your income, hopefully there is some left
too.
How did you go? You might need to cut your amounts back a little. We will look at that soon.
then include budgets for Christmas, birthdays, annual bills, any need or want that is not monthly:
Now do totals, put in your income and find what is left each month:
Also, your first budget may not be very realistic. Expenses are going to come along that you didn't think of.
That is OK, it is part of your learning experience.
What if you don't have money left over? Well, you can:
Reducing Expenses
Go over your budget and think carefully how you can reduce each item.
When you spend money, put it in the "Actual" column for that month. Try to discipline yourself not to go over
your budget.
Wrong way: I just got paid $2500. After all expenses I should have $500 left, so I can spend $500 on a new
game console!
Right way: I have spent $40 of my $100 "fun" budget, so I can spend $60 on games.
Wrong: those $200 shoes are on sale for $120. If I buy them I am saving $80
Also remember that the excitement of buying often leads to a let down feeling later. Stay within your budget to
always feel good about yourself.
Envelopes
This helps some people:
Take out cash from the bank and put it in individual budget envelopes.
You can only spend from the envelopes.
Emergency Fund
Next, put money aside for emergencies. Things break down and need replacing or repair (plumbers are
expensive). Your pet might need a vet. A friend might need help.
At least $2,000. More if you can (some people suggest 3 months salary worth).
Having emergency money also gives you a good sense of confidence in life.
Investments
When you have paid off your high interest debt, and have money in an emergency fund it is time to think about
investing Learn more about investing.
Annuities
An annuity is a fixed income over a period of time.
So:
Example (continued):
Seems like a good deal ... you get back more than you put in.
Why do you get more income ($24,000) than the annuity originally cost ($20,000)?
The people you give the $20,000 to could invest it and earn interest, or do other clever things to make more
money.
Value of an Annuity
First: let's see the effect of an interest rate of 10% (imagine a bank account that earns 10% interest):
Your first payment of $500 is next year ... how much is that worth now?
Your second payment is 2 years from now. How do we calculate that? Bring it back one year, then bring it back
another year:
The third and 4th payment can also be brought back to today's values:
PV = $500 × 3.169865...
PV = $1584.93
There are 60 monthly payments, so n=60, and each payment is $400, so P = $400
PV = $400 × 44.95504...
PV = $17,982.02
Say you have $10,000 and want to get a monthly income for 6 years, how much do you get each month (assume
a monthly interest rate of 0.5%)
P = PV × r/ 1 − (1+r)−n
Say you have $10,000 and want to get a monthly income for 6 years out of it, how much could
you get each month (assume a monthly interest rate of 0.5%)
P = PV × r/ 1 − (1+r)−n
P = $10,000 × 0.016572888...
P = $165.73
Footnote:
You don't need to remember this, but you may be curious how the formula comes about:
We can use exponents to help. 1/ 1+r is actually (1+r)−1 and 1/ (1+r)×(1+r) is (1+r)−2 etc:
To simplify that further is a little harder! We need some clever work using Geometric Sequences and Sums but
trust me, it can be done ... and we get this:
PV = P × 1 − (1+r)−n /r