2 What is Interest?The rate a financial institution charges for the money it lendsThe rate rises and falls (fluctuates)The “prime” interest rateDescribes the standard interest rate set by The Bank of Canada
3 Changes in Interest Rate There are many reasons that the interest rates go up and downThe EconomyWhen 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 rateWhen the economy is doing poorly (recession) – less borrowing leads to a lower interest rate
4 Interest Rates effect on Saving In a period of inflation - prices are increasingAs such banks need to pay a higher interest rate to make up for the rising pricesExample: 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 fallsExample: In 2000 you give the same investment. A couple years later you can now buy $1.10 worth of goods/servies
5 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, spendThis 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
6 Interest Rates effect on Investing Bonds – will pay you interest on a principle that you invest for a said period of timeThe 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 usuallyHowever, if the bank interest rate rises above the interest rate of the bond – the price you can sell it for now decreases
7 Interest Rate effect on Investing ExampleYou put away $1000 into a bond for 6 years at 6% interest will pay you $ at the bond maturity date. So, that is the market valueIf the interest rate goes up to 7% you would have to sell it for a cheaper price to entice a buyerIf the interest rate goes down you can charge a higher price
8 Interest Rates effect on Investing Stocks are risky and don’t offer a guaranteed return on your moneyAs we have all found out in the stock market gameSo, when interest rates are high – people would rather play it safe and invest in things like bondsStock prices then tend to fallWhen interest rates are low – more people look for a risky pay outStock prices then tend to rise
9 Calculating Simple Interest Here comes the math!!!The formula for calculating interest is a simple one:I = PrtI = Interest P = Principle r= annual interest rate t = time
10 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?
11 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?
12 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?
13 Compound InterestCompound 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.
14 Compound Interest and Formula Formula for Compound InterestFV = P( 1 + i )tFV 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.ExampleIf 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.
15 Compound Interest Examples Initial money being invested = $1000/month @2% Interest RateCalculationInterest EarnedTotal ValueYear 12.00%Year 2Year 3Year 4Formula = M = P( 1 + i )n
16 Compound Interest Examples Initial money being invested = $1000/month @2% Interest RateCalculationInterest EarnedTotal ValueYear 12.00%1000x0.02201020Year 21020x0.0220.40Year 3x0.0220.81Year 4x0.0221.22Formula = M = P( 1 + i )n