3. How Interest is Earned
a. Time value of money
The time value of money is an idea that a dollar today is worth more than a dollar tomorrow due to inflation or its buying capacity. The value of a dollar changes dramatically depending upon when you get it and what you do with it.
Say you have $100 today. If you keep it in your house for a year, you will still have $100 at the end of the year. But if inflation during that year is 3 percent, the $100 item that you wanted to buy a year ago will have increased 3 percent and now costs $103. Your $100 will have lost value because you now need $3 more to buy the same item. In this case, a dollar today is worth more than the same dollar next year.
But if you put the $100 in a bank savings account and you earn 3 percent, then at the end of the year, your $100 is now worth $103. The item you want to buy now costs $103 so your account has kept up with inflation. Better in the bank than under the mattress!
It pays to save early and often.
It’s not rocket science. You can master the three factors that affect how much your savings dollars grow.
- The earlier or longer you save, the more savings you will have.
- The more money you save each year, the more savings you will have.
- The higher the interest rate or rate of return, the more savings you will have.
Before we go any further explaining how interest works, check out this short video about the magic of compound interest
and how it helps money grow over time.