MONEY 22 - INVESTMENT CALCULATIONS

THIS IS MY 22^ND POST ON UNDERSTANDING MONEY TOOLS

Money, Money, Money.  In the last post we covered simple interest, compound interest and rates of return.

 Let’s talk about quick ways to figure out how an investment might look without a lot of figuring.  There is a rule of 7 and 10.  That means that you are going to be close in figuring compound interest using these two numbers if you want to make 7% or 10% on your money.  If I make an investment at 7% it will take me 10 years to double my money.  If I make an investment at 10% it will take me 7 years to double my investment.

What if you want to get an approximate return on investment other than 7% or 10%?  Some people use the rule of 72 to figure how long it takes to double money.  In this case, divide the percent you are receiving into 72.  An example is an investment at 9% and you want to know how long it will take to double your money?  Divide 9 into 72, and the answer is 8 years.  72 is most commonly used, as many numbers can be divided into it without decimal places.  It is a quick estimate,  The more accurate number to use is 69.3, or even 70, a whole number.

Have you heard of APR?  Annual percentage rate may be different from the interest rate quoted to you at time of purchase of a home or car.  There are essentially two types of APR.  Nominal APR is the same as simple interest on a loan, as we have discussed.  Compound APR, or effective rate, takes the simple interest on a loan and then adds in extra charges to the loan, this may include service fees, loan origination fees, transportation and set up fees on cars.  On mortgages the big ones are appraisal fees, loan origination fees and perhaps PMI or private mortgage insurance.

Here is an illustration:

Nominal APR: $100 for one year and cost of money is $5.  Therefore divide $100 into $5 and you will get .05. Move the decimal point two places to the right and you get 5%.

Now, let’s assume the same $5 in cost of money and the same $100 loan for one year under compound APR. We need to add in all costs for the loan.  Let’s assume $.50 for loan origination, another $.50 for service fees, and $1. for filing fees with public recorder’s office.  The extra charges on the loan are $2. thus we have $7 instead of $5.  Now, divide $100 principal amount of loan into $7 and you will get .07.  Again, move the decimal point two places to the right and you will see your loan interest rate is not 5%, but in actuality 7%. These additional costs are normally paid up front, however they are amortized over the length of the loan.

You’ve probably heard the terms “future value” of money and “present value” of money. 

Future Value: Future value of money is the value of money at a certain time in the future that would be equal to today’s value.  This is similar to interest rate returns we have talked about to date.  As an example, if inflation is running at 3% in the USA, after a year what amount of money would I need to have the same purchasing power as I do today if I held $100?  The answer is $103.

Present Value: This is the opposite of future value.  You take a figure in the future and bring the amount back to the current value, based upon facts or assumptions like inflation rate. In other words you are discounting the value of money back to today.