Investing Lessons for Teens
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Interest
Interest is an amount paid out by people or banks to borrow money. It is commonly represented as a percentage of the principal, or loan amount. There are two types of interest; simple and compound. Simple interest is calculated only on the principal amount, so that $100 dollars at 5% interest would pay $5 each year. Compound interest differs in that it also factors in accumulated interest as well as principal. That same $100 dollars at 5% interest would pay $5 in the first year. But compounded annually, in the second year the interest would be $5.25, because the interest would be calculated on $105, which is the original principal of $100 as well as the accumulated interest $5. All other factors being equal, funds grow quicker when compounded annually rather than with simple interest.
Interest is an amount paid out by people or banks to borrow money. It is commonly represented as a percentage of the principal, or loan amount. There are two types of interest; simple and compound. Simple interest is calculated only on the principal amount, so that $100 dollars at 5% interest would pay $5 each year. Compound interest differs in that it also factors in accumulated interest as well as principal. That same $100 dollars at 5% interest would pay $5 in the first year. But compounded annually, in the second year the interest would be $5.25, because the interest would be calculated on $105, which is the original principal of $100 as well as the accumulated interest $5. All other factors being equal, funds grow quicker when compounded annually rather than with simple interest.
Inflation
Inflation is the idea that the purchasing power of money decreases over time. Another term, deflation, is the opposite, when the purchasing power of money increases over time. Purchasing power is the relative comparison of how many units of good a unit of money can buy at different periods of time. For example, a dollar bill that once could have bought an ice cream cone loses purchasing power if the price of the ice cream cone increases over time. Because of the effect of interest, we generally expect inflation to occur over time.
Inflation is the idea that the purchasing power of money decreases over time. Another term, deflation, is the opposite, when the purchasing power of money increases over time. Purchasing power is the relative comparison of how many units of good a unit of money can buy at different periods of time. For example, a dollar bill that once could have bought an ice cream cone loses purchasing power if the price of the ice cream cone increases over time. Because of the effect of interest, we generally expect inflation to occur over time.
As an example, this chart illustrates the decreased purchasing power of the dollar over time in the U.S. due to inflation:
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Effective Buying Power
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Average Income New Car New House Loaf of Bread Gallon of Gas Gallon of Milk Minimum Wage |
1950
$3,216 $1,511 $8,450 $0.14 $0.18 $0.84 $0.75 |
1960
$5,199 $2,610 $12,675 $0.20 $0.26 $1.04 $1.00 |
1970
$9,357 $3,979 $23,400 $0.24 $0.36 $1.32 $1.60 |
1980
$19,173 $7,201 $68,714 $0.51 $1.19 $2.02 $3.10 |
1990
$28,906 $16,012 $123,000 $0.70 $1.34 $2.78 $3.80 |
2000
$41,343 $24,800 $134,120 $1.26 $1.72 $3.24 $5.15 |
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Rule of 72
The Rule of 72 is a helpful formula to help you quickly approximate the number of years it will take for a sum of money to double at a given interest rate compounded annually.
The Rule of 72 is a helpful formula to help you quickly approximate the number of years it will take for a sum of money to double at a given interest rate compounded annually.
Years to double = 72 / Interest rate
In order to approximate how long it would take for an amount to double at 10% interest, you would divide 72 by 10 to get about 7 years. You can rearrange the formula to figure out the rate at which an investment received interest.
Interest rate= 72 / Years investment was held
If you were told that a sum of money doubled in 12 years (compounded annually), you could approximate the interest rate by dividing 72 by 12 to see that it earned interest at a rate of 6% annually. The following table shows approximations calculated from the rule of 72 for various interest rates
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Interest Rate
1% 2% 3% 4% 5% 6% |
Years to Double an Investment
72.0 36.0 24.0 18.0 14.4 12.0 |
In general, there is a noticeable effect to reducing the interest rate. For example, if you were to accept 3% interest rather than 6% interest, you would have to wait approximately 24 years for that investment to double, rather than 12 years. Remember that the rule of 72 is only an approximation.
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