Saturday, January 30, 2010

What does Future Value mean?

So I've been using a term called Future Value of money. What exactly does this mean?

Well I usually give this example of saving $1000 a year for 30 years at 10% return annually.

That means after Year 1 you will have $1100 = $1000 (principal) + $100 (10%).
After Year 2 you have $1210 = $1100 (Principal) + $110 (10%)
And you continue this process for 30 years. That is if you just saved $1000 that first year. You will have $17,449.40 after 30 years. Not bad for letting your money sit in your investment.

Your equation should be for a single deposit at year 1:

Future Value = Savings (1 + rate)^Years

Now what if you continually save $1000 every year (also known as an annuity)? Your future value would be the sum of the above equations for each year.

FV(annuity) = FV(30 years) Year 1 + FV(29 years) + ... + FV(1 year)

So the formula is:
FV(annuity) = ((1 + rate)^years - 1)/rate * savings

So if you saved $1000 every year for 30 years and 10% return at the end of the year you will have:
FV = ((1 + 10%)^30 - 1) / 10% * $1000
FV = ((1.1)^30 - 1) / 10% * $1000
FV = 16,449.40 * $1000
FV = $164,494

Not bad for only $1000 a year. Enough to buy a cheap condo in the DC area. Note also that it's the money at the beginning that is compounding the most and as you near the end of your 30 years, those $1000 are insignificant in relation to the early deposits. What does that mean? That means start saving EARLY!

Plug it into this Future Value Calculator if you don't believe me. Play around with it, see how much if you save $50, $100, $150 each year. You'd be surprised how much you can save.

What can a budget do for you?

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