Simple And Useful Financial Concepts To Be Aware Of

Simple and Useful Financial Concepts To Be Aware Of: The Rule of 72, Compound Interest, Add on Interest, Crossover Point, Time Value of Money and Internal rate of return. What they are, what they're used for, and how we compute or come up with them.
In my opinion, personal finance is mostly about sitting down, thinking, and making the right choices. It's very unlike the school work we were made to do when we were young. We don't need to memorize anything.

However there are some concepts that would serve us well to be aware of.

The Rule of 72 - or how to know when you're money will double. In my opinion this is mostly a motivational tool. Anything that earns higher than a time deposit (or Special Deposit Account, previously) isn't guaranteed, making this formula more of a guestimate than a rule. But still, few methods out there can motivate people to save and invest more than knowing they could double their money in a relatively short time by just waiting.

So what's the formula?
72/R = T
R = rate of return (i.e. 10 for 10% per annum)
T = Years (Time) it would take to double the amount.

So Php10,000 at 20% average annual interest would take roughly 3.6 years to double, but at 5% would take roughly 14.4 years.

Fun fact: Did you know that there are no less than 5 ways to compute when your money will double? Aside from 72, there's 70, 69.3, 72(adjusted), and the EM-rule. The other rules can actually be more accurate, depending on the rate of return involved.

Compound Interest - In my opinion, the best way to accumulate wealth. The only thing you need to worry about is getting a high interest (to speed up the process) and having enough time to let it do it's work.

Take your money (capital), let it earn interest, and then let the interest earn interest along with your capital.

For a great article on the power of compound interest, we can refer to Fitz' blog post on it.

Add-on Interest - Not all interest rates are created equal. With this type of interest, you pay interest on the entire amount, even when you've paid up 95% of the loaned amount. In other words, the interest payment remains the same, no matter how much you've already paid. Learn more about this "sneaky" interest rate from Investor Juan.

Crossover point - or how to know how much money you need to accumulate to be financially free. In my opinion, this is the most motivating concept out there. It puts a real price on how much you need to accumulate. From there, you can make plans to reduce expenses and invest more to achieve freedom.

The formula is simple: Crossover point = Average Annual Expenses / Interest Rate

Where interest rate = the investment returns (i.e. 8% from a mutual fund)

I first learned this from Anthony of Each Peso Counts, however the blog appears to be down right now. But we can still read about it from his guest post in Fitz' site.

Time Value of Money - Money is worth more today than it will be tomorrow. Instinctively, we all get this; if only because of inflation. However, it's not just about inflation, it's also about your money's potential. But we'll get to that later.

Internal Rate of Return - Or how to check if an investment is really profitable. Okay, this one isn't so simple to grasp at first (at least it wasn't for me), but the formula is simple enough (in a spreadsheet, at least).

Usually you can use this to check which opportunity offers the better chance to profit (ex. whether that business or rental property will give you better returns than if you simply invested the money in a UITF).

To illustrate better the time value of money and how to use the internal rate of return, we can read Investor Juan's post.

That's it. It's a pretty quick post. If you would like to keep reading about useful personal finance stuff, please subscribe to my feed, like me on Facebook, circle me on Google+, or follow me Twitter @thePFApprentice. It's free, you won't miss new articles, and you'll also get my free ebook: the Super Savings Guide.

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photo credit: D.C.Atty via photopin cc

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