The money has time value. A rupee today is more valuable than a rupee one year hence. The inflation reduces the purchasing power of money. In this article we will understand about the future value of money.
The future value of money depends upon the type of interest accrued on investment. There are two method of calculating interest:
In simple interest, the interest earned on investment is accrued uniformly during the period of investment.
Suppose you invest Rs 1,000 for five year in saving account that pays 10% simple interest per year. Then the value of investment after five year will be as follows:
Here you see that Principle remains same throughout the period of investment.
The general formula for calculating the future value of money invested today at simple interest is:
Future value = Present Value [1 + Number of year x Interest Rate]
Also written in short form as:
FVn = PV (1 + nr)
PV = Present value
FVn = Future value of money n years hence
r = Interest Rate
n = number of years
If the money is invested at compound interest then the interest is reinvested to earn further interest in future periods.
Suppose you invest Rs 1,000 for five year in saving account that pays 10% compound interest per year. Then the value of investment after five year will be as follows:
Future value = Present Value [1 + Interest Rate]Number of years
FVn = PV (1 + r)n
Let’s now compare the difference between simple interest and compound interest through the table given below:
You must have understood the power of compounding. Einstein has once described compound interest as “the eighth wonder of the world”.
Under simple interest the growth is linear whereas under compound interest the growth is exponential.
People commonly ask the question: How long would it take to double the amount at a given rate of interest? The rule of 72 answers this question. According to this rule, the doubling period is obtained by dividing 72 by the interest rate. Suppose if interest rate is 9 percent, then the double period is about 72/9 = 8 years. Thus it takes 8 years to double the amount at 9 percent rate of interest.
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