Question

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

150 words or more please - I cannot understand the material thoroughly if it less than 150!

Answer 1

Let us assume a Principal amount of P with number of years N and rate of interest r.

Then simple interest can be shown as PNR/100 . Now if the number of periods increase the only change in the interest amount is with respect to change in N

For example, if N is 5 years the simple interest is 5*N*R/100. If the N increases to 10 years, then Simple interest is 10*N*R/100 ie 2 times the simple interest for 5 years.

Thus, we see that the simple interest increases linearly with the increase in number of years N.

Time value of money is a concept which says that the dollar that is worth today is more than the same dollar tomorrow due to the concept of opportunity cost. The metric that captures the opportunity cost is the interest rate.

In the above example, every year 5% interest is paid on the Principal and this increases linearly with the number of years.