Functions for Personal Finance
This section details how loans work and the different parts of the PMT function. Pay attention to Table 2.6, which shows the arguments (or inputs) of the PMT function.
Time Value of Money Concepts
In reviewing the Budget Summary worksheet in Figure 11 Calculating the Savings Rate, you will notice that the range B9:D14 contains data that can be used to assess a savings plan. We can project how much money can be saved over a specific period of time given set contributions and a rate of return. This calculation is accomplished through the future value, or FV, function. We will use the FV function in cell D10 of the Budget Summary worksheet to calculate our savings plan projection. However, before we use the FV function, it is important to review a few basic concepts regarding the time value of money, as shown in Table 3 Key Terms for Time Value of Money Concepts.
| Argument | Definition |
|---|---|
| Annuity | An investment that is made in regular payments over a period of time. For example, depositing $100 a month into an interest-bearing bank account or mutual fund is considered an annuity. |
| Bonds | An investment in which you lend money to a company or government entity. The borrower agrees to pay you interest over a specific period time. At the end of the bond agreement, the amount of money that was borrowed, or your initial investment, is returned to you. Most bonds are considered a lower risk investment but offer a lower rate of return than stocks offer. |
| Mutual Funds | A collection of similar investments managed by a financial professional called a fund manager. Mutual funds allow you to invest in several stocks or bonds without having to make many individual investments. They also allow you to reduce your risk and take advantage of the investment expertise of a professional. |
| Rate of Return | The percentage gained or lost on an investment. Investments that offer a high predicted rate of return often carry a higher risk of losing money. Investments that offer a lower predicted rate of return often carry a lower risk of losing money. |
| Stocks | An investment in which you own a portion of a company. The value of this investment increases as the company produces higher profits. Most stocks are expected to generate a higher rate of return than bonds generate. However, the risk of losing money on a stock investment is much greater than the risk for bonds. |
Table 3 Key Terms for Time Value of Money Concepts
Table 3 Key Terms for Time Value of Money Concepts provides definitions for several terms used when addressing the time value of money concepts. The time value of money is the opportunity to grow your
money over time given a constant or average rate of return. For example, consider the data shown in Figure 12 Time Value of Money Example for a One-Time Investment. This data assumes that a person makes a one-time investment of $100
in a bond mutual fund that returns five percent interest per year. Notice that the interest paid in Column E increases every year. This is because the interest is reinvested in the mutual fund, which increases the total value of the investment. For
example, the interest earned in year one is based on a $100 investment. Therefore, the interest paid is $5.00, or five percent\ of $100. However, in year \two, when the $5.00 interest payment is reinvested, the total investment increases to $105.
Therefore, in year two the interest paid increases to $5.25, or five percent of $105. The value of the investment at the end of five years is $127.63. This is the value that can be calculated using the FV function.
Figure 12 Time Value of Money Example for a One-Time Investment
Figure 13 Time Value of Money Example for an Annuity Investment shows another example demonstrating the time value of money concept. Instead of making a one-time investment, we will assume that a person invests $100 at the beginning of every year in the same bond mutual fund. This is referred to as an annuity because the person is making reoccurring investments over a specific period of time. Notice that the value of this investment after five years is $580.19. Also, the total interest earned on this investment is $80.19 as opposed to the $27.63 earned on the one-time investment in Figure 12 Time Value of Money Example for a One-Time Investment.
Figure 13 Time Value of Money Example for an Annuity Investment