Compound Interest and the Time Value of Money

Saving and investing work because of two fundamental financial concepts; compound interest and the time value of money. It is vital that you are comfortable understanding how these two concepts work.

To make sure you are comfortable with compound interest and the time value of money, we will give you the definitions and equations used in calculating them. If this works for you, then great; if it doesn't - just hang out for a few minutes and read through the rest of this chapter. 

Compound Interest and Time Value of Money
Compound Interest Time Value of money
  • It can be applied to both investing and debt
  • When you compound interest, you're not only earning interest on the original amount that you invested but the original amount plus the interest you made on top of that!
  • Formula: A = P (1 + r/n) (nt)
  • Explanation of terms:

    • A = the future value of the investment/loan, including interest
      P = the principal investment amount (the initial deposit or loan amount)
      r = the annual interest rate (decimal)
      n = the number of times that interest is compounded per year
      t = the number of years the money is invested or borrowed for.

       
  • The concept that a sum of money you have NOW is worth more than in the future because you can save or invest today's dollars at a given interest rate. (Earning potential)
  • Formula: FV = PV x (1 + (i / n)) ^ (n x t)
  • Explanation of terms:

    • FV = Future value of money

      PV = Present value of money

      i = interest rate

      n = number of compounding periods per year

      t = number of years
   

 

Why they matter

When you are able to take advantage of compound interest and the time value of money you will be able to see your savings and investments grow faster than they would if you were just stashing away money in your mattress. It is always advisable to save early and often but this general advice is not just so that you can put more of your money aside. Saving and investing early and often gives you the fullest benefits of compound interest and the time value of money.

You may think that it will be easier to save later when you have more money or when you get that promotion or raise but it's less about the dollar amount you put away and more about establishing the habit. 

It is always going to take discipline to set aside some of your hard-earned money to grow so that you can achieve future goals, but you can do it. We advise that at a minimum you put away at least 10% of every dollar that you ever make starting today. Notice that it's not a dollar amount -it's a percentage of your income. There will always be things in life that could sidetrack your saving and investing ( kids, cars, houses, loans, college, medical expenses ) so it is vital to establish your saving and investing habits early and stick to them. 

Even waiting just a few years to get started can cost you significant amounts of money over your lifetime. 

Cost of Waiting(www.investingtips360.com/Links to an external site.)

 

As you begin to consider saving and investing opportunities for yourself you will want to think about three main factors that will have a lasting impact on your ability to take advantage of compound interest and the time value of money. 

  • The interest rate that you will be earning will play a major role in your decision-making process. What is the interest rate you are earning on the money in your savings account? What should you expect to earn on an investment that you make in the stock market? You should be researching and asking yourself this question every time you are deciding to put away some money.

 

  • The length of time you plan on keeping the investment matters. Remember that the longer you keep an investment or savings account the more time you have to take advantage of compound interest. For each financial goal that you have, you should be thinking about how long you will keep the investment active. Are you building an emergency fund? Maybe you are planning on buying a house in ten years. What about your retirement plans? Each of these goals have different time periods associated with them.

 

  • The frequency with which your money is compounded is a huge consideration. At its basic form, this is how often your interest is calculated and applied. For example, you would be better off putting money in an account paying 8% compounded monthly, rather than a similar account paying 10% but compounded annually.