personal finance chapter 3
Describe how you can use the Rule of 72 to make financial planning decisions.
-"ballpark estimate" of how long it takes for a sum of money to double in value. -to project how prices will double through inflation.
What is compound interest? How is compound interest related to the time value of money?
-Compound interest is interest paid on interest. -growth of a sum of money over a period of time, also known as compounding.
What is "future value" and why is it important to calculate?
-Future value is the value of a certain sum of money at a certain future point in time. -it allows us to project how much "growth" a certain rate of return will provide.
Define an amortized loan and give two common examples.
An amortized loan is one that is paid off in equal periodic payments over time. Two common examples are car loans and home mortgages.
Why do you think that Albert Einstein once called compound interest the "eighth wonder of the world"?
Einstein knew that, given sufficient time, compound interest could truly work wonders. Over time, even small dollar amounts can grow into incredible sums. The sooner money is saved, the more time it has to grow.
What two factors most affect how much people need to save to achieve their financial goals?
Interest rate: the amount earned on an investment Time: the number of years during which compounding occurs
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?
Investors require a greater return because of the increased uncertainty of the future purchasing power of their investment as the time horizon lengthens. It is almost human nature to err on the side of having too much; therefore, the further we try to project our needs, the greater the "average need" becomes.
Explain in terms of the future-value interest factor why, given a certain goal, that as the period of time to invest increases, the required periodic investment decreases.
The future-value interest factor gives a numeric representation of the power of compounding. This shows that as the investment horizon lengthens the total return becomes more a factor of compound interest and less a factor of subsequent investments.
Why is it necessary to use a negative present value when solving for N (the number of payments) or I/Y (the rate of return)? Similarly, why does the answer have a negative sign if positive payments were used when solving for a future value on a calculator?
The sign, either + or -, used when entering a time value of money equation dictates the direction of the cash flow.
Explain the concept of the time value of money. Explain two ways this concept is relevant in financial planning.
The time value of money is the concept that a dollar received today is worth more than a dollar received tomorrow
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?
· FV—the future value of a sum of money held for N years · N— the number of periods (e.g., years) of compounding · I/Y—the annual interest rate, commonly referred to as either the compound (FV) or discount (PV) rate · PV—the present (current) value of a sum of money