Understanding and Using Present Values

One of the most valuable additions to a savers toolkit is the present value calculation. Even though it comes off as a bit scary at first, the amount of value it creates as a tool for understanding our financial position by putting the numbers right in front of us. By using the present value function, we can then start to look at how it is that our future obligations and investments impact us today.

equationsThe present value equation looks at money that we will be receiving at a later date, and tells us how much that amount of money is worth to us today. From there, we can compare the different aspects of our financial position to find out which obligation should take on a higher priority to pay off first, or which investment is worth more to us in the longer term.

To calculate the present value of a payment schedule, we need to know the number of payments that will be made/received, the number of periods in which we will receive these payments, and the interest rate under which these payments will be operating. From there, we multiply the dollar value of the payments by the inverse of the interest rate, less the interest rate multiplied by its full percentage amount, to the power of the number of periods in which we will receive/pay those payments. Don’t let the verbal explanation confuse you, it’s much simpler when you see it symbolically: Continue reading

Understanding Compound Interest

Keeping track of personal finances can be a somewhat daunting task for anyone. Between the hassle associated with rounding up all of the proper documents, the potential for disappointment when we see that we might be behind our financial goals, and the sheer amount of time that we need to spend making sure that we are setting ourselves back on track, it’s fairly easy to find an excuse to procrastinate this task off to another day.

compound interest equationHowever, financial planning doesn’t need to be a chore, and can actually be a fairly seamless process for an informed saver. The trick is to understand the financial math that goes into our daily lives, so that we can better see how our money is working in our daily lives, and what we need to do to make our savings work for us.

The most fundamental calculation for a personal saver to understand is the compounding interest equation. Compounding interest, as a concept, makes up the basis of any kind of banking, and is therefore has an impact on our savings, borrowing, and investing. Simply put, compounding interest represents the way in which an interest rate is broken down to accumulate on a daily basis, so as to be most efficient.

When interest compounds it will result in a higher interest amount being paid (or received), but also represent a much more efficient amount than simple interest (which is just paid off at the end of the period). From a debt perspective, we will see later on how it is that compounding interest is the reason why a debt is so cumbersome in the first half of a loan period, while it creates a much more appealing return from an investment and savings perspective. Continue reading