Lesson 2 - Value of Money - Part 1

What happens to your money over time?

A major component in Financial Planning seems like a simple question.  What happens to our money over time?  This is important because we need to calculate how much we might need in retirement, or how much that dream vacation, or sending your children to school.  All of these events occur in the future, so how much do we need to save? Or how much annually do we need to save?  These are all important questions in helping us achieve our goals.

We must develop different ways to determine how much money we will need for a future event.  There are two major methods of solving this, Compounding and Discounting.

Compounding is generally broken down into two areas:

1.       Single payment

2.       Multiple payments (Annuity)

Single Payment

If you invested 1,000 dollars today for 3 years and earned 10 percent return, how much would we have at the end of three years?  This is known as the future value (FV)

Lets look at the simple equation:

A.      FV at the end of year 1 = 1,000 + 10%(1,000) = $1,100

B.      FV at the end of year 2 = 1,100 + 10%(1,100) = $1,210

C.      FV at the end of year 3 = 1,210 + 10%(1,210) = $1,331

So how much will our 1,000 dollar investment be worth at the end of 3 years earning 10% a year? $1,331 dollars.  The method above uses a Compounding amount.  Meaning the 10% return we receive in the first year ($100) also earns 10% interest in the second year.

If for example an investment is listed as Simple Interest, then we only earn our 10% return on the initial investment ($1,000) throughout its lifespan.

Example/ 1,000 x 10% x 3 years = $1,300.  With Simple Interest, our investment has only earned $300 dollars, compared with $331 from Compounding Interest.