8/20/2012 2:15 PM ET|
9 money rules to live by
Here's what you should take away: You'll almost certainly need to take some market risk if you want to grow your wealth and beat inflation over time. But you should also be wary of anyone who "guarantees" a high return on an investment. If you're earning much more than the going rate on a T-bill, you're taking some risk, and you should understand that risk before proceeding.
8. The time value of money
This boils down to a relatively simple proposition: that the dollar I get today is worth more than a dollar I'm promised sometime in the future.
There are several reasons for this. One is the "bird in the hand" reality: The dollar I get today is real, but the dollar I'm promised in the future likely will be worth less (because of inflation), or I might not get it at all (you might renege on your promise to give it to me, or die, or cease operations if you're an employer or business). Also, the dollar I get today can be invested to create more dollars in the future.
Turn this around, and you'll see why lenders charge interest for loaning money -- and why the interest rate depends on your creditworthiness. Lenders want to be compensated for the erosion in their dollars due to inflation, and for the risk of lending money to you.
The higher the perceived rate of future inflation and the more lenders doubt your promise to pay the money back, the more interest they'll charge to compensate for the risk.
9. The miracle of compound interest
This is a concept best illustrated by example. Let's say I give you a penny today, and promise to double the amount every day for a full month. How much money would I be giving you on the 31st day?
The answer: $10.7 million. Check it out:
|It all adds up|
Each day, the "interest" I paid you the previous day earns more interest. At the beginning, the amounts are nominal, but by the end we're talking big bucks.
Of course, no one's going to double your money every day. But this concept explains how people who save relatively small amounts over the years can build rather substantial nest eggs. After a few decades, their actual contributions represent only a small part of their burgeoning wealth -- it's mostly their returns that are earning returns.
But this also illustrates how debts can quickly balloon out of control. If you're paying interest, rather than incurring it, and you're not diligent about paying off the finance charges in full every month, the unpaid amount will incur additional interest charges, increasing the total amount that you owe. This is why so many families who incur credit card debt eventually find themselves in trouble as the amounts they owe explode past their ability to pay.
There are plenty more nifty and helpful money concepts, but these nine are among my favorites.
Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.
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