Personal Finance Chapter 3
Describe the effects and benefits of compound interest.
Compounding interest means that interest earned on the principal of an investment or savings vehicle is reinvested and will itself earn interest. Should the interest earned be removed and not reinvested then you wonʹt accumulate a very large amount.
What recommendations would you offer to someone who is trying to break poor financial habits and save money in order to achieve his or her financial goals?
Recommendation one: First, gain an understanding of how compounding works-that as the number of years and the interest rate you earn go up, so does the future value of an investment. Recommendation two: Think of savings as a ʺsnowball effect.ʺ You earn interest on your initial investment, and those interest earnings and the initial investment both continue to earn interest. When these earnings are extended over multiple decades, your money can really add up. In other words, you want to start investing as soon as possible. Recommendation three: Pay yourself-your future self, that is-first. To make this process as painless as possible, automate the payments so that when your paycheck is deposited into your bank account, a percentage is automatically transferred to a separate investment account-perhaps your retirement account. Or ask your employerʹs payroll department about a mandatory payroll deduction. It is much easier to save the money that you never really see!
Describe the two factors that affect how much we need to save to achieve financial goals.
The two variable factors that affect total accumulation are the interest rate received and the time period the savings/investment is allowed to accumulate. Increasing the interest rate and/or the period of time to accumulate will create a much larger end product. By decreasing either of these two factors, total accumulation will be decreased. Experiment with increasing either of these factors and the results will be both apparent and amazing.
What are some practical uses of present and future values?
There are basically two practical uses for these values. Present values will tell you how much must be saved or invested annually to achieve a future financial goal. It also works for determining the monthly payment on a loan of a specified amount to be paid back in the future. Future values show the total future accumulated values of specified sums of money saved or invested now and into the future. Budgeting and financial planning would be very difficult if not impossible without the time value of money skills.
List at least five common examples of annuities.
a one year lease on an apartment, your five year car loan, your parentsʹ mortgage payments, monthly savings to reach a college education expense goal, a monthly paycheck if you are on salary, and constant monthly contributions to retirement plans are all examples of annuities.
List four reasons why you should care about the power of compounding and the time value of money.
1.The concepts are critical to your efforts to achieve financial goals. 2.The sooner you start saving for retirement, the less you have to save each year. 3.You may outlive your Social Security benefits and employer retirement plans. 4.The concepts will help you develop a large estate for yourself, spouse, and children.
Define an amortized loan and give two common examples..
An amortized loan is a loan paid off in equal installments. The loan amount is paid back by spreading or amortizing the payments out over a certain time period based on a specific interest rate. Two common examples are auto loans and home mortgages.
A compound interest table is useful in solving a time value of money problem. Name the variables involved.
The interest rate, the period of time involved, the sum of money involved, and the frequency of compounding are variables to consider when using a compound interest table.
Why is the time value of money an important concept in financial planning?
The time value of money allows us to see the relationship between time and the value of accumulated sums of money. We can clearly understand that starting a savings or retirement plan at a younger age will create much more wealth than waiting to start it at a later time. It also becomes clear that starting younger means saving a smaller monthly amount and having the option of skipping some months or years later if it becomes necessary to do so.
