Question

Explain the concept of time value of money in the context of simple interest. How would you use this in retirement planning?

Answer 1

Simple interest concept is very simple to understand and use it in our daily life. The concept of time value of money means that an individual's capital will no longer be the same after a certain period of time but will increase by a certain amount. The reason behind the same is the growth of any economy per se, which includes few economic indicators such as Inflation, unemployment rate, demand and the overall consumption behaviour of people.  

Lets understand this from an example.

Suppose a person named Joe has invested a sum of $ 1000 in a financial instrument at a certain simple interest rate of 5%. Then, Joe will be receiving a total sum of $ 50 every year. So, Joe's income is increased by $ 50 every year. In short, the value of money is increased by a certain % based on the inflation rate, say 2% (must be less than the Simple interest rate). In fact, the same amount of $ 1000 will value $ 1002 after a period of one year, considering the inflation rate of 2%. So, Joe should invest his money to get a return which should be at least equal or greater than the annual inflation rate of the country, else Joe's fund value will depreciate.

The same concept can be applied in the retirement planning wherein Joe can invest a sum of his idle funds in any financial instrument giving a higher interest rate for a longer period so that he can avail the benefits of return earned as the interest rate every year after the maturity period.

To conclude, Simple interest is very useful in loan, borrowing funds, or purchasing anything on simple interest. Whereas, Compound interest is preferred while planning any investment for long term such as Retirement, Insurance, Child education etc.