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This is my rudimentary explanation of basic financial concepts found in Chapter 37. I am writing this for my own good and hope someone else benefits from this information. I do not want to become caged some day. It's easy stuff to use once learned, as anything is. The rub is that learning is generally not easy.
Do not despair! Behind every simple event is a long, tumultuous process. In fact, the event is a very small slice of that process. After re-reading the information several times - perhaps 10 or more - applying it will be easy cake.
I'm very lucky that MJ decided to include a list of financial concepts to study in his book, The Millionaire Fastlane .
Interest & Interest Rates
Interest Rates
The proportions of loans that are charged as interest to the borrower.
Loans are borrowings of money from the lender to the borrower. This money, known as principal, has to be returned from the borrower to the lender within a certain amount of time (a period); otherwise, the lender bills the borrower for the use of this money. The amount of the bill is called interest, determined by the interest rate.
Simple Interest
Interest on principal.
If the interest rate on the money I borrowed was 2.5% per period, I borrowed $100, and I wasn't able to pay anything after one period, I would owe $2.50 in interest after the period. If the lender wanted to apply the interest ten times during that period, I'll owe $0.25 for each application of interest.
After the eighth application in that period, I'll owe $2.00 in interest. If I paid $100 to the lender, that payment would first go towards interest, and then towards my principal.
Thought Process:
I borrowed $100 from my lender. I now owe my lender $100.
The interest by the eighth application of the period has accrued to $2.00.
If I make a payment of $100, I'll pay interest, leaving me with $98 left to pay for principal.
After my $98 payment, I owe my lender $2.
After the ninth application in that period, the lender will accrue 2.5% interest on the $2 I owe; I'll now owe half a penny.
Compound Interest
Interest on principal and interest.
If the interest rate is 2.5% per period, I borrow $100, and the lender wants to apply interest twice, I'll owe 1.25% interest on both the principal and interest for each application. The collection of the principal and the interest in dollars owed is known as the balance. After the first application, my balance is $101.25. After the second application, I'll owe 1.25% of my $101.25 balance. The interest builds up, or compounds, per mini-period. The lender receives $102.52 (rounded), two more cents than simple interest. It appears as if the interest per period was actually 2.52%!
The Simple Difference (and Commonality)
Simple interest applies interest to principal whereas compound interest applies it to both principal and interest.
The commonality? Pay off your loans as soon as you can so you don't have to pay at each application!
Formulas
I've decided against including the formulas. It complicates a simple concept.
The Market Sets Interest Rates
If many people want to lend money, and no one wants to take it, you bet that I'll be looking for a 1.2% APR (annual interest rate, known as an annual percentage rate). If there's no lenders in sight except for the one located at the Great Mesa, rest assured everyone will march towards him and still take a 10% APR.
But Not Always
Where do the lenders even get *their* money from? Central, federal banks throughout the world exist and may intake or release their monies, depending on what governments want. With more of the money in the Federal Reserve and less money for the lenders, the value of the dollar will increase. Therefore, dollar interest rates will go up. This process removes money from the US economy, also known as a money sink.
Bonds also move money from the public to the owner(s) of the bonds. As most would say, the "rich get richer". A gold nugget of an anecdote about bonds is hidden in The Millionaire Fastlane .
What happens to the price of a bond when interest rates increase? (This isn't rhetorical; I don't actually know this.)
Protection for the Lender
If the borrower isn't reliable on paying back loans, the lender may charge a higher APR.
If the borrower is late on payments, the lender may begin to bill a default interest rate. This rate is much higher than the original and "serves to compensate the lender for the added risk".
An Interesting Way To Use Interest Rates
Negative interest rates were proposed by "free" thinkers such as Silvio Gesell. A negative interest rate meant that you deposit money in a bank and see less of it at the end of the day. You have to either use the bank, which most wouldn't want, or carry the money. That implied more risk, however - what if money was just lost due to wind, robbery, fire, or other external circumstances? Others such as John Keynes liked the idea of imposing a carrying tax on money. Nowadays, we just have inflation, which is what Keynes also recommended, and serves the same purpose.
Do not despair! Behind every simple event is a long, tumultuous process. In fact, the event is a very small slice of that process. After re-reading the information several times - perhaps 10 or more - applying it will be easy cake.
I'm very lucky that MJ decided to include a list of financial concepts to study in his book, The Millionaire Fastlane .
Interest & Interest Rates
Interest Rates
The proportions of loans that are charged as interest to the borrower.
Loans are borrowings of money from the lender to the borrower. This money, known as principal, has to be returned from the borrower to the lender within a certain amount of time (a period); otherwise, the lender bills the borrower for the use of this money. The amount of the bill is called interest, determined by the interest rate.
Simple Interest
Interest on principal.
If the interest rate on the money I borrowed was 2.5% per period, I borrowed $100, and I wasn't able to pay anything after one period, I would owe $2.50 in interest after the period. If the lender wanted to apply the interest ten times during that period, I'll owe $0.25 for each application of interest.
After the eighth application in that period, I'll owe $2.00 in interest. If I paid $100 to the lender, that payment would first go towards interest, and then towards my principal.
Thought Process:
I borrowed $100 from my lender. I now owe my lender $100.
The interest by the eighth application of the period has accrued to $2.00.
If I make a payment of $100, I'll pay interest, leaving me with $98 left to pay for principal.
After my $98 payment, I owe my lender $2.
After the ninth application in that period, the lender will accrue 2.5% interest on the $2 I owe; I'll now owe half a penny.
Compound Interest
Interest on principal and interest.
If the interest rate is 2.5% per period, I borrow $100, and the lender wants to apply interest twice, I'll owe 1.25% interest on both the principal and interest for each application. The collection of the principal and the interest in dollars owed is known as the balance. After the first application, my balance is $101.25. After the second application, I'll owe 1.25% of my $101.25 balance. The interest builds up, or compounds, per mini-period. The lender receives $102.52 (rounded), two more cents than simple interest. It appears as if the interest per period was actually 2.52%!
The Simple Difference (and Commonality)
Simple interest applies interest to principal whereas compound interest applies it to both principal and interest.
The commonality? Pay off your loans as soon as you can so you don't have to pay at each application!
Formulas
I've decided against including the formulas. It complicates a simple concept.
The Market Sets Interest Rates
If many people want to lend money, and no one wants to take it, you bet that I'll be looking for a 1.2% APR (annual interest rate, known as an annual percentage rate). If there's no lenders in sight except for the one located at the Great Mesa, rest assured everyone will march towards him and still take a 10% APR.
But Not Always
Where do the lenders even get *their* money from? Central, federal banks throughout the world exist and may intake or release their monies, depending on what governments want. With more of the money in the Federal Reserve and less money for the lenders, the value of the dollar will increase. Therefore, dollar interest rates will go up. This process removes money from the US economy, also known as a money sink.
Bonds also move money from the public to the owner(s) of the bonds. As most would say, the "rich get richer". A gold nugget of an anecdote about bonds is hidden in The Millionaire Fastlane .
What happens to the price of a bond when interest rates increase? (This isn't rhetorical; I don't actually know this.)
Protection for the Lender
If the borrower isn't reliable on paying back loans, the lender may charge a higher APR.
If the borrower is late on payments, the lender may begin to bill a default interest rate. This rate is much higher than the original and "serves to compensate the lender for the added risk".
An Interesting Way To Use Interest Rates
Negative interest rates were proposed by "free" thinkers such as Silvio Gesell. A negative interest rate meant that you deposit money in a bank and see less of it at the end of the day. You have to either use the bank, which most wouldn't want, or carry the money. That implied more risk, however - what if money was just lost due to wind, robbery, fire, or other external circumstances? Others such as John Keynes liked the idea of imposing a carrying tax on money. Nowadays, we just have inflation, which is what Keynes also recommended, and serves the same purpose.
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