Maroon Money Management Money. They say it can't buy happiness, but some days it seems like the lack of it can buy some unhappiness. This week, the iKnowMaroon series discusses some important concepts in personal finance and money management. In finance classes, you learn about the time value of money. This all revolves around opportunity costs and interest. Unless you are dealing with very good friends, you probably would not lend them $100 today and tell them that they can simply pay back $100 next year. You would want them to pay you more than $100 next year, because you will lose the opportunity to use that $100 throughout the entire year. You will charge them interest. The interest rate is a measure of the time value of that money. Interest rates are typically stated in annual terms, so 4% means 4% per year. If you charge 4% interest on that $100, then the person will pay back the principal of the loan (the original $100), plus $4.00 in interest (.04 times $100). There are two types of interest for longer loans: simple and compound. With simple interest, each year that the person takes to repay your $100 loan, they will owe you $4 in interest (for that year). If the person borrows the money for five years, at the end of the five years they will owe you $120. $100 borrowed for 5 years, simple 4% interest Principal End of Year Interest for this year Total owed at end of year $100 1 $4.00 $104.00 2 $4.00 $108.00 3 $4.00 $112.00 4 $4.00 $116.00 5 $4.00 $120.00 With compound interest, however, each year, the interest is calculated not as simply 4% of the original $100, but 4% of the amount owed at the end of the previous year. At the end of Year 2, for instance, the interest owed is 4% of the $104.00 owed at the end of Year 1. At the end of Year 3, the interest owed is 4% of the $108.16 owed at the end of Year 2. $100 borrowed for 5 years, 4% interest compounded annually Principal End of Year Interest for this year Total owed at end of year $100 1 $4.00 $104.00 2 $4.16 $108.16 3 $4.33 $112.49 4 $4.50 $116.99 5 $4.68 $121.67 As you can see, charging compound interest rather than simple interest gets you an extra $1.67. Not much on this loan, maybe, but it can be really significant on large loans, over more years. MSU's Maroon Money Management web site includes three financial calculators that can be very useful in real everyday life. Go to the freshman.msstate.edu web site, and click on the button for Maroon Money Management. You will see a calculator that is a Loan Calculator. Let's say you're looking to buy a house. Maybe the house costs $200,000, and you have saved $20,000 that you can use on the downpayment (that means you depart with that $20,000 on the day that you buy the house – you pay that up front). You will borrow $180,000. Let's say home mortgage loans are currently charging 4.00% interest (home mortgage interest rates can change daily, and could skyrocket or plummet any day, depending on what's going on in the world). It is common to take 30 years to pay off a home mortgage. These are the only three pieces of information that you need for this calculator: the amount that you're borrowing, the annual interest rate, and how many years you will take to pay off the loan. Enter these three values into the loan calculator. Press the Calculate button. Look at your loan analysis. You borrowed $180,000. Your monthly payment will be $859.35. You will make that monthly payment for the next 30 years (360 months). Ouch. You will pay back the original $180,000 that you borrowed, plus a whopping $129,364.17 in interest. Wow, that seems like a lot of interest! You can use the Loan Calculator to do what if analyses. What if interest rates fell to 3% (it would save you $36,165.45!). What if I paid the loan back in 25 years instead of 30 (your monthly payment would go up to $950.11, but it would save you $24,333.06 in the long run). You will see two other great financial calculators on the Maroon Money Management web site. You can use the Repayment Time Calculator to see how long it will take you to pay off a loan. Let's say you have $10,000 in student loan debt, and you are to pay 4% interest. If you pay back $100 per month, how long will it take you to pay back the entire loan? (answer: 10 years and 2 months) You can use the Wealth Accumulator Calculator to plan your retirement. If you start saving as soon as you graduate and get a great job, and can save $250 per month over a 30-­‐year work career, earning 6% interest, you will accumulate $251,128.80 for your retirement. Over a quarter of a million dollars. Nice. Personal Finance and Money Management are parts of our everyday lives. It will pay if we understand the main concepts.