Personal Finance Chapter 3

What is compound interest? How is compound interest related to the time value of money?

Compound interest is interest paid on interest. It results from the reinvestment of interest paid on an investment's principal value. As time goes on your interest accumulates and you get more money.

What is a perpetuity? Name an example of a perpetuity in personal finance.

A perpetuity is an annuity that continues on forever. An example is a share.

Why do you think that Albert Einstein once called compound interest the "eighth wonder of the world"?

Albert Einstein once called compound interest "the eighth wonder of the world" because it proves how much money you can have form investing. If you double your money starting with a penny for a month, you will end with over $10 million.

What is the primary difference between an annuity and a compound annuity?

An annuity is a series of payments over a specific period of time whereas a compound annuity is an investment of the series of payments for a certain number of years.

Why is it necessary to use a negative present value when solving for N or I/Y? Similarly why does the answer have a negative sign if positive payments were used when solving for a future value on a calculator?

Negative signs are needed because it is money going out of your pocket so you need to make it clear to the calculator that it is a loss of money. Future value would come up negative if you left present value positive because you need at least one negative in the equation because at least one aspect is money leaving your pocket. This is because you need to spend money in order to make money off an investment.

What is the relationship between present-value and future-value interest factors and present and future interest factors for annuities?

Present value and future value interest factors and present and future interest factors for annuities are inverse of each other.

Describe how you can use the Rule of 72 to make financial planning decisions.

The Rule of 72 can be used to calculate how many years it will take for your investment to double. 72/2% = 36 years to double - You can use this to determine when you will have enough money to make large financial decisions.

What is "future value" and why is it important to calculate?

The future value is the value of your investment at some point in the future. It is important to calculate so that way you know how much you will have at a certain point in the future and you can determine if you need to add money annually.

Why might an investor require a greater expected return for an investment of longer maturity? Do you feel you can forecast inflation 2 years from now with greater accuracy than inflation in 20 years?

The investor requires a greater return because inflation goes up, which means that the money is worth less but they still want the same amount it was worth when they first invested their money. Yes because the trend will be more accurate sooner rather than later and there are more variables for 20 years later.

What variables are used in solving a time value of money problem with no periodic payments? Which of these variables equals zero when solving a simple present- or future-value problem with no periodic payments? Why?

The variables used are N (Period) which is the total number of compounding periods, I/Y (Interest Rate) is the interest rate per a certain amount of time, PV (Present Value) is the amount of money you initially put in and FV (Future Value) is the money you will have at a certain point in the future. PMT (or Payment) equals zero because you are not putting any money into the investment during the growth.

Why might you use the anticipated rate of inflation as the discount rate when calculating present value?

We use the discount rate to bring future money back to the present because the dollar value of the future money is not as powerful as the purchasing value of the money. For example if we wanted to know what future money would buy in today's dollars we could figure it out.

What two factors most affect how much people need to save to achieve their financial goals?

What you want to have is one factor and what you are willing to save are the two factors that affect how much people need to save to achieve their financial goals.

Why is the interest rate in a time value of money calculation sometimes referred to as the discount rate? Why is it also called "inverse compounding"?

It is sometimes referred to as a discount rate because it is the rate that is used to bring future money back to the present or to discount the money back to the present. It is called inverse compounding because you are doing the inverse of what you normally do. You are going from the future to the present.

Define an amortized loan and give two common examples.

Loans that are payed in equal periodic payments. Two examples are car loans and mortgages.

Explain the concept of the time value of money. Explain two ways this concept is relevant in financial planning.

Time value of money means that the longer you invest for, the more money you will have in the future. It can help people plan important events in their life due to when they will have enough money for it. It can also help people determine their wealth at a specific point in their life and know how much they will need at this point.