Download 5a. Interest

Interest
What is Interest?
• The rate a financial institution charges for the money
it lends
• The rate rises and falls (fluctuates)
• The “prime” interest rate
– Describes the standard interest rate set by The Bank of
Canada
Changes in Interest Rate
• There are many reasons that the
interest rates go up and down
– The Economy
• When the economy is doing well – people want to buy
large items – they need to borrow money – the
demand for money goes up and so does the interest
rate
• When the economy is doing poorly (recession) – less
borrowing leads to a lower interest rate
Interest Rates effect on Saving
– In a period of inflation - prices are increasing
• As such banks need to pay a higher interest rate to
make up for the rising prices
• Example: In 2000 you put $1.00 in the bank. During the
next couple of years inflation occurs and now that
$1.00 can only buy $0.90 worth of goods/services.
– In a period of deflation – The cost of goods fall.
• As such banks do not need to pay a high interest rate
and it falls
• Example: In 2000 you give the same investment. A
couple years later you can now buy $1.10 worth of
goods/servies
Interest Rates effect on Spending
• When interest rates are high – people are
spending more money paying off their debts
(mortgages)
• When interest rates are low – people don’t
see a point in saving and can easily pay off
their debts – so they will spend, spend, spend
– This is one of the reasons interest rates go down
in a recession – as we learned the best way to get
out of a recession is to spend
Interest Rates effect on Investing
• Bonds – will pay you interest on a principle
that you invest for a said period of time
– The institution that issues the bond must pay a
higher interest rate than the banks (otherwise
people would just put their money in a bank)
– Bonds are transferable usually
• However, if the bank interest rate rises above
the interest rate of the bond – the price you
can sell it for now decreases
Interest Rate effect on Investing
• Example
– You put away $1000 into a bond for 6 years at 6%
interest will pay you $1418.52 at the bond
maturity date. So, that is the market value
– If the interest rate goes up to 7% you would have
to sell it for a cheaper price to entice a buyer
– If the interest rate goes down you can charge a
higher price
Interest Rates effect on Investing
• Stocks are risky and don’t offer a guaranteed
return on your money
– As we have all found out in the stock market game
• So, when interest rates are high – people would
rather play it safe and invest in things like bonds
– Stock prices then tend to fall
• When interest rates are low – more people look
for a risky pay out
– Stock prices then tend to rise
Calculating Simple Interest
• Here comes the math!!!
• The formula for calculating interest is a simple
one:
I = Prt
I = Interest
t = time
P = Principle
r= annual interest rate
Calculating Simple Interest
• Example 1:
• If You were to invest $530 in a savings account
that paid 1.5% interest for two years, how
much interest would you make?
Calculating Simple Interest
• Example 2:
• If You were to invest $1000 in a GIC that paid
you 5% interest for 5 years, how much money
would you receive on the date the GIC
matured?
Compounding Simple Interest
• If I invest $300 at an interest rate of 3.5% for 9
months and You invested $400 at an interest
rate of 2.25% for 1 year – who would earn
more interest?
Compound Interest
Compound interest is
interest that is paid on
both the principal and also
on any interest from past
years. It’s often used when
someone reinvests any
interest they gained back
into the original
investment.
Compound Interest and Formula
• Formula for Compound
Interest
– FV = P( 1 + i )t
• FV is the final amount
including the principal.
• P is the principal amount.
• i is the rate of interest per
year.
• t is the number of years
invested.
• Example
• If I got 2% interest on my
$1000 investment, the first
year and I reinvested the
money back into the
original investment, then in
the second year, I would get
2% interest on $1000 and
the $20 I reinvested. Over
time, compound interest
will make much more
money than simple interest.
Compound Interest Examples
Initial money being invested = $1000/month @2%
Interest Rate
Calculation
Interest Earned
Year 1
2.00%
Year 2
Year 3
Year 4
Formula = M = P( 1 + i )n
Total Value
Compound Interest Examples
Initial money being invested = $1000/month @2%
Interest Rate
Calculation
Interest Earned
Total Value
Year 1
2.00%
1000x0.02
20
1020
Year 2
1020x0.02
20.40
1040.40
Year 3
1040.40x0.02
20.81
1061.21
Year 4
1061.21x0.02
21.22
1082.43
Formula = M = P( 1 + i )n
Compound Interest Examples
Initial money being invested = $1000/month @ 2%
FV = P(1+r)t
Compound Interest Examples
Initial money being invested = $1000/month @ 2%
FV = P(1+r)t
FV = 1000 (1.02)4
FV = 1000(1.082432)
FV = 1082.43
Interest Assignment