Interest - Financial Management

Money can be thought of as having a time value. In other words, an amount of money received today is worth more than the same dollar amount would be if it were received a year from now.1 The primary reason that a dollar today is worth more than a dollar to be received sometime in the future is that the current dollar can be invested to earn a rate of return. (This holds true even if risk and inflation are not considerations.) Suppose, for example, that you had $100 and decided to put it into a savings account for a year. By doing this, you would temporarily give up, or forgo, spending the $100 however you wished, or you might forgo the return that the $100 might earn from some alternative investment, such as U.S. Treasury bonds. Or you might forgo paying an additional $100 on your mortgage. Similarly, a bank that loans money to a firm forgoes the opportunity to earn a return on some alternative investment.

Interest is the return earned by or the amount paid to someone who has forgone current consumption or alternative investment opportunities and “rented” money in a creditor relationship. The principal is the amount of money borrowed or invested. The term of a loan is the length of time or number of time periods during which the borrower can use the principal. The rate of interest is the percentage on the principal that the borrower pays the lender per time period as compensation for forgoing other investment or consumption opportunities.

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