Explain the concept of the time value of money
- Because money can be invested and interest earned on the investment, money has time value.
- An implication of money having time value is that $1 is worth less the later it is received, all other things equal
- Another implication of money having time value is that you cannot add amounts at different points in time; amounts have to be added at the same point in time
Explain the benefits of compounding
With compound interest, you earn interest upon interest. So over time the value of an investment will grow considerably
Explain the implications of changing the frequency of compounding
- The more frequently interest is compounded, the more interest that is earned, and, holding all else constant, the greater the future wealth from an investment
- With simple interest, interest is compounded once over the life of the investment
Explain the relationship of effective interest rates and nominal interest rates
- The nominal interest rate is an interest rate stated over a certain period but that is not compounded at the same frequency as the period stated
- The effective interest rate is an interest rate stated over a certain period and that is compounded at the same frequency as the period stated.
- An effective annual interest rate is an interest rate compounded once per year
- A nominal annual interest rate is an interest rate stated on an annual basis but is not compounded once per year
- Interest rates can only be compared when they are compounded at the same frequency