What Is a Loan?

A loan is money, property, or other material goods given to another party in exchange for future
repayment of the loan value or principal amount, along with interest or finance charges. A loan
may be for a specific, one-time amount or can be available as an open-ended line of credit up to
a specified limit or ceiling amount.

Loan

Loans are typically issued by corporations, financial institutions, and governments. Loans allow
for growth in the overall money supply in an economy and open up competition by lending to
new businesses. Loans also help existing companies expand their operations. The interest and
fees from loans are a primary source of revenue for many banks, as well as some retailers
through the use of credit facilities and credit cards.

How a Loan Works

The terms of a loan are agreed to by each party in the transaction before any money or property
changes hands. If the lender requires collateral, this requirement will be outlined in the loan
documents. Most loans also have provisions regarding the maximum amount of interest, as well
as other covenants such as the length of time before repayment is required.

KEY TAKEAWAYS

 A loan is when money or assets are given to another party in exchange for repayment of
the loan principal amount plus interest.
 Loans with high interest rates have higher monthly payments—or take longer to pay
off—versus low-rate loans.
 Loans can be secured by collateral such as a mortgage or unsecured such as a credit
card.
 Revolving loans or lines can be spent, repaid, and spent again, while term loans are
fixed-rate, fixed-payment loans.
Types of Loans
A number of factors can differentiate loans and affect their costs and terms.

Secured vs. Unsecured Loan

Loans can be secured or unsecured. Mortgages and car loans are secured loans, as they are
both backed or secured by collateral.

Loans such as credit cards and signature loans are unsecured or not backed by collateral.
Unsecured loans typically have higher interest rates than secured loans, as they are riskier for
the lender. With a secured loan, the lender can repossess the collateral in the case of default.
However, interest rates vary wildly on unsecured loans depending on multiple factors, including
the borrower's credit history.

Revolving vs. Term

Loans can also be described as revolving or term. Revolving refers to a loan that can be spent,
repaid and spent again, while term loans refer to a loan paid off in equal monthly installments
over a set period. A credit card is an unsecured, revolving loan, while a home-equity line of
credit (HELOC) is a secured, revolving loan. In contrast, a car loan is a secured, term loan, and
a signature loan is an unsecured, term loan.
Special Considerations for Loans
Interest rates have a significant effect on loans and the ultimate cost to the borrower. Loans with
high interest rates have higher monthly payments—or take longer to pay off—than loans with
low interest rates. For example, if a person borrows $5,000 on an installment or term loan with a
4.5% interest rate, they face a monthly payment of $93.22 for the next five years. In contrast, if
the interest rate is 9%, the payments climb to $103.79.

Loans with high interest rates have higher monthly payments—or take longer to pay off—than
loans with low interest rates.
Similarly, if a person owes $10,000 on a credit card with a 6% interest rate and they pay $200
each month, it will take them 58 months, or nearly five years, to pay off the balance. With a 20%
interest rate, the same balance, and the same $200 monthly payments, it will take 108 months,
or nine years, to pay off the card.

Simple vs. Compound Interest

The interest rate on loans can be set at a simple interest or a compound interest. Simple
interest is interest on the principal loan, which banks almost never charge borrowers.

For example, let's say an individual takes out a $300,000 mortgage from the bank, and the loan
agreement stipulates that the interest rate on the loan is 15% annually. As a result, the borrower
will have to pay the bank the original loan amount of $300,000 x 1.15 = $345,000.

Compound interest is interest on interest and means more money in interest has to be paid by
the borrower. The interest is not only applied to the principal but also the accumulated interest
of previous periods. The bank assumes that at the end of the first year, the borrower owes it the
principal plus interest for that year. At the end of the second year, the borrower owes it the
principal and the interest for the first year plus the interest on interest for the first year.

The interest owed, when compounding is taken into consideration, is higher than that of the
simple interest method because interest has been charged monthly on the principal loan
amount, including accrued interest from the previous months. For shorter time frames, the
calculation of interest will be similar for both methods. As the lending time increases, the
disparity between the two types of interest calculations grows.

Reference: Kagan, J. (2019). Loan. Investopedia. Retrieved from

https://www.investopedia.com/terms/l/loan.asp

A loan for a specific purpose. For example, a mortgage is a transaction loan because it is used to buy a
piece of property, a fact both the lender and the borrower know when they begin the process. A transac
tion loan contrasts with a line of
credit, which may be used for any number of purposes within a broad range.

Reference: Transaction loan. (n.d.) Farlex Financial Dictionary. (2009). Retrieved September 17 2019
from https://financial-dictionary.thefreedictionary.com/Transaction+loan
LENDER
Murray, J. (2019). What is lending and types of lenders. Retrieved from
https://www.thebalancesmb.com/what-is-lending-what-are-lenders-398319

What Is a Lender?

Lenders are businesses or financial institutions that lend money, with the
expectation that it will be paid back. The lender is paid interest on the loan as a
cost of the loan. The higher the risk of not being paid back, the higher the interest
rate.

Lending to a business (particularly to a new startup business) is risky, which is

why lenders charge higher interest rates and often they don't give small business
loans.

Lenders do not participate in your business in the same way as shareholders in a

corporation or owners/partners in other business forms. In other words, a lender
has no ownership in your business.

Lenders have a different kind of risk from business owners/shareholders.

Lenders come before owners in terms of payments if the business can't pay its
bills or goes bankrupt. That means that you must pay lenders back before you
and other owners receive any money in a bankruptcy.

The most common lenders are banks, credit unions, and other financial
institutions.

What Is a Lender? Barone, A. (2019). Lender. Retrieved from

https://www.investopedia.com/terms/l/lender.asp
A lender is an individual, a public or private group, or a financial institution that makes funds
available to another with the expectation that the funds will be repaid. Repayment will include
the payment of any interest or fees. Repayment may occur in increments (as in monthly
mortgage payment) or as a lump sum.

Understanding Lenders
Lenders may provide funds for a variety of reasons, such as a mortgage, automobile loan or
small business loan. The terms of the loan specify how the loan is to be satisfied, the period of
the loan, and the consequences of default. One of the largest loans consumers take out are
home mortgages.

Special Considerations
Qualifying for a loan depends largely on the borrower's credit history. The lender examines the
borrower's credit report, which details the names of other lenders extending credit, what types of
credit are extended, the borrower's repayment history and more. The report helps the lender
determine whether the borrower is comfortable managing payments based on current
employment and income.

The lender may also evaluate the borrower's debt-to-income (DTI) ratio comparing current and
new debt to before-tax income to determine the borrower's ability to pay.
Lenders may also use the Fair Isaac Corporation (FICO) score in the borrower's credit report to
determine creditworthiness and help make a lending decision.

When applying for a secured loan, such as an auto loan or a home equity line of credit, the
borrower pledges collateral. An evaluation will be made of the collateral's value, and the existing
debt secured by the collateral is subtracted from its value. The remaining equity affects the
lending decision.

The lender evaluates a borrower's available capital. Capital includes savings, investments and
other assets which could be used to repay the loan if household income is insufficient. This is
helpful in case of a job loss or other financial challenge. The lender may ask what the borrower
plans to do with the loan, such as use it to purchase a vehicle or other property. Other factors
may also be considered, such as environmental or economic conditions.

Examples of Lender
Banks, savings and loans, and credit unions may offer Small Business Administration (SBA)
programs and must adhere to SBA loan guidelines. Private institutions, angel investors, and
venture capitalists lend money based on their own criteria. These lenders will also look at the
nature of the business, the character of the business owner and the projected annual sales and
growth for the business.

Small business owners prove their ability for loan repayment by providing lenders both personal
and business balance sheets. The balance sheets detail assets, liabilities and the net worth of
the business and the individual. Although business owners may propose a repayment plan, the
lender has the final say on the terms.

KEY TAKEAWAYS

 A lender is an individual, a public or private group, or a financial institution that makes

funds available to another with the expectation that the funds will be repaid.
 Repayment will include the payment of any interest or fees.
 Repayment may occur in increments (as in monthly mortgage payment) or as a lump
sum.

BORROWER

Vancity. (2019). Your responsibilities as a borrower. Retrieved from

https://www.vancity.com/Loans/UnderstandingLoans/Responsibilities/
 Your responsibilities as a borrower

When you agree to borrow money from a lender, you enter into a legal contract. It’s your responsibility to ensure
that you fully understand this contract before you sign it. Your signature tells the lender that you agree to meet your
obligations by repaying the loan according to the contract.

Things to consider if you can't make a loan payment

It can happen to anybody. So if you are unable to make a monthly payment, here’s what you should do:

 Contact the creditor immediately, before the payment due date. Your call demonstrates your good faith. Most
creditors are willing to make alternative arrangements if your situation has changed.
 Don't wait until the due date has passed or until the creditor calls you. Waiting puts you at a disadvantage when
dealing with your creditor and that’s the last thing you want.
 Ask for a grace period. If it's a one-time occurrence, your creditor may give you a grace period, allowing you time to
get your financial affairs in order.
 Renegotiate your loan terms. If your situation has permanently changed, your creditor may extend the term of the
loan. That will spread your payments over a longer period of time, giving you room to breathe each month and
reduce your stress.

The consequences of ignoring your loan obligations

A loan is a legal obligation. If you fail to meet the terms of the loan agreement, your creditor has the right to take
court action against you to recover the balance of the debt. This could happen in several ways.

 If the loan is secured by a chattel mortgage, the creditor is entitled to take possession of the property that you have
signed over as security. The creditor can then sell the property and apply the proceeds against the outstanding
balance of the loan.
 If there is no chattel mortgage on the loan, or if you did not pledge any assets as security, the creditor can obtain a
court order. A court order grants access to other goods that you own, which similarly can be sold to compensate for
the default.
 If your spouse or some other person co-signed your loan application, the creditor will usually transfer the demand
for payment to that person.
 If you were the sole signer, your creditor may resort — again by court order — to garnisheeing your wages. This
means that the money you owe to the creditor will be paid directly by your employer. Until the full amount of the
debt is repaid, your earnings will no longer pass through your hands.
You can probably prevent these consequences by being proactive and taking the steps outlined above. If your
financial difficulties are serious and you cannot resolve them yourself, then you should consider credit counselling.
These services are available through your lending institution or through an independent agency.

The last resort

If you are in over your head and can’t work out an arrangement with your creditors, then as a last resort you can
declare personal bankruptcy. Bankruptcy will free you from most, if not all, of your debts. But it’s a painful
experience and you’ll pay a very high price for this freedom. All of your assets other than your personal essentials
may be sold by a bankruptcy trustee. Other than the money to cover the trustee's fees, the proceeds from the sale will
be distributed to your creditors. What’s more, a bankruptcy stays on your credit record for a number of years. It will
take considerable time and effort on your part to restore your credit rating. Bankruptcy is a drastic step, and may
cause you and your family a great deal of hardship.
KEY VARIABLES
Principal Chen, J. (2019). Principal. Retrieved from
https://www.investopedia.com/terms/p/principal.asp

The principal is a term that has several financial meanings. The most commonly used refers to
the original sum of money borrowed in a loan or put into an investment. Similar to the former, it
can also refer to the face value of a bond.

The principal can also refer to an individual party or parties, the owner of a private company or
the chief participant in a transaction.

Principal

Financing Principal
In the context of borrowing, principal refers to the initial size of a loan; it can also mean the
amount still owed on a loan. If you take out a $50,000 mortgage, for example, the principal is
$50,000. If you pay off $30,000, the remaining $20,000 left to repay is also called the principal.

The amount of interest one pays on a loan is determined by the principal sum. For instance, a
borrower whose loan has a principal amount of $10,000 and an annual interest rate of 5% will
have to pay $500 in interest for every year the loan is outstanding.

When you make monthly payments on a loan, the amount of your payment goes first to
cover accrued interest charges, and the remainder is applied to your principal. Paying down the
principal of a loan is the only way to reduce the amount of interest that accrues each month.

Zero Principal Mortgage

Also known as an "interest-only mortgage," a zero principal mortgage is a type of financing in
which the borrower's regular payments cover only the interest charged on the loan, as opposed
to both interest and principal. As a result, the borrower does not make any progress reducing
the loan's principal balance – on paying off the overall debt – or on building equity in the
mortgaged property.

For this reason, zero principal mortgages are usually not in a homebuyer's best interest.
However, there are some instances when they would be useful for some individuals. If a
borrower is just beginning a career in which he or she currently receives relatively little pay but
will likely earn significantly more in the near future, then it might be advantageous to take such a
loan now in order to buy a residence. Then, when income increases, refinance to a conventional
mortgage that includes principal payments. Also, if an individual has access to an exceptional
investment opportunity, promising large returns on cash, it would, in theory, make good financial
sense to take advantage of the mortgage's smaller interest-only payments, and then use the
extra money for the investment.

Original Investment
The principal is also used to refer to the original amount of investment, separate from
any earnings or interest accrued. Assume you deposit $5,000 into an interest-bearing savings
account, for example. At the end of 10 years, your account balance has grown to $6,500. The
$5,000 you initially deposited is your principal, while the remaining $1,500 is attributed to
earnings.

Face Value of a Bond

In the context of debt instruments, the principal can refer to the face value, or par value, of a
bond – that is, the actual amount listed on the bond itself. A bond's principal is, essentially, the
amount of money the issuer of the bond owes to the bondholder in full upon the
bond's maturity. The bond's principal is exclusive of any coupon, or recurring interest payments,
or accrued interest (although the issuer is obligated to pay these as well). For instance, a 10-
year bond may be issued with $10,000 face value and have $50 recurring coupon payments
semi-annually. The principal is $10,000 – independent of the $1,000 worth of coupon payments
over the life of the bond.

A bond's principal is not necessarily the same as its price. Depending on the state of the bond
market, a bond may be purchased for more or less than its principal. For example, in October
2016, Netflix issued a corporate bond offering. The face value or principal of each bond was
$1,000, and at issue, that was the price of each bond as well. Since then, the bond price has
fluctuated between $1,040 and $1,070, but the principal has remained the same – $1,000.

Does Inflation Affect Principal?

Inflation does not affect the nominal value of the principal of a loan, bond or other financial
instruments. However, inflation does erode the real value of the principal.

Suppose the U.S. government issues $10 million worth of 10-year U.S. Treasury bonds. Each
treasury has a face value, or principal, of $10,000. If the average annual rate of inflation over
the next 10 years is 4 percent, then the real value of those bonds at maturity is only
$6,755,641.69. Yes, the principal balance remains $10,000, and that's the nominal sum
bondholders receive. But the value of that $10,000 (what it can buy) has declined to, effectively,
$6,755.64. In other words, the principal has only 67 percent of its original purchasing power.

Bondholders can still recoup their original costs if the value of the interest income the bond has
generated is greater than the lost principal value. They can track the amount of return, or yield,
they're getting on a bond. There's the bond's nominal yield, which is the interest paid divided by
the principal of the bond, and its current yield, which equals the annual interest generated by the
bond divided by its current market price.

Private Companies
The owner of a private company is also referred to as a principal. This is not necessarily the
same as a CEO. A principal could be an officer, shareholder, board member or even a key sales
employee – the primary investor or the person who owns the largest share of the business. A
company may also have several principals, who all have the same equity stake in the concern.
Anyone considering investing in a private venture will want to know its principals, in order to
assess the business' creditworthiness and potential for growth.

Responsible Party
The term "principal" also refers to the party who has the power to transact on behalf of an
organization or account and takes on the attendant risk. A principal can be an
individual, corporation, partnership, government agency or nonprofit organization. Principals
may elect to appoint agents to operate on their behalf.
The transaction a principal is involved in could be anything from a corporate acquisition to a
mortgage. The term is usually defined in the transaction’s legal documents. In those documents,
the principal means everyone who signed the agreement and thus has rights, duties, and
obligations regarding the transaction.

When a person hires a financial adviser, he or she is considered a principal while the adviser is
the agent. The agent follows instructions given by the principal and may act on his or her behalf
within specified parameters. While the adviser is often bound by fiduciary duty to act in the
principal's best interests, the principal retains the risk for any action or inaction on the part of the
agent. If the agent makes a bad investment, it is still the principal who loses the money.

SIMPLE INTEREST
Chen, J. (2019). Simple interest. Retrieved from
https://www.investopedia.com/terms/s/simple_interest.asp
What Is Simple Interest?
Simple interest is a quick and easy method of calculating the interest charge on a loan. Simple
interest is determined by multiplying the daily interest rate by the principal by the number of
days that elapse between payments.

This type of interest usually applies to automobile loans or short-term loans, although
some mortgages use this calculation method.

Understanding Simple Interest

Understanding Simple Interest

When you make a payment on a simple interest loan, the payment first goes toward that
month’s interest, and the remainder goes toward the principal. Each month’s interest is paid in
full so it never accrues. In contrast, compound interest adds some of the monthly interest back
onto the loan; in each succeeding month, you pay new interest on old interest.

To understand how simple interest works, consider an automobile loan that has a $15,000
principal balance and an annual 5-percent simple interest rate. If your payment is due on May 1
and you pay it precisely on the due date, the finance company calculates your interest on the 30
days in April. Your interest for 30 days is $61.64 under this scenario. However, if you make the
payment on April 21, the finance company charges you interest for only 20 days in April,
dropping your interest payment to $41.09, a $20 savings.

KEY TAKEAWAYS

 Simple interest is calculated by multiplying the daily interest rate by the principal, by the
number of days that elapse between payments.
 Simple interest benefits consumers who pay their loans on time or early each month.
 Auto loans and short-term personal loans are usually simple interest loans.
Who Benefits From a Simple Interest Loan?
Because simple interest is calculated on a daily basis, it mostly benefits consumers who pay
their loans on time or early each month. Under the scenario above, if you sent a $300 payment
on May 1, then $238.36 goes toward principal. If you sent the same payment on April 20, then
$258.91 goes toward principal. If you can pay early every month, your principal balance shrinks
faster, and you pay the loan off sooner than the original estimate.

Conversely, if you pay the loan late, more of your payment goes toward interest than if you pay
on time. Using the same automobile loan example, if your payment is due on May 1 and you
make it on May 16, you get charged for 45 days of interest at a cost of $92.46. This means only
$207.54 of your $300 payment goes toward principal. If you consistently pay late over the life of
a loan, your final payment will be larger than the original estimate because you did not pay
down the principal at the expected rate.

What Types of Loans Use Simple Interest?

Simple interest usually applies to automobile loans or short-term personal loans. Most
mortgages do not use simple interest, although some banks use this method for mortgages for
bi-weekly payment plans. Bi-weekly plans generally help consumers pay off their mortgages
early because the borrowers make two extra payments a year, saving interest over the life of
the loan by paying off the principal faster. (For related reading, see "4 Ways Simple Interest Is
Used in Real Life")

Interest Rate
Hayes, A. (2019). Interest rate floor definition. Retrieved from
https://www.investopedia.com/terms/i/interestratefloor.asp

What Is an Interest Rate Floor?

An interest rate floor is an agreed-upon rate in the lower range of rates associated with a
floating rate loan product. Interest rate floors are utilized in derivative contracts and loan
agreements. This is in contrast to an interest rate ceiling (or cap).

Interest rate floors are often used in the adjustable rate mortgage (ARM) market. Often, this
minimum is designed to cover any costs associated with processing and servicing the loan. An
interest rate floor is often present through the issuing of an ARM, as it prevents interest rates
from adjusting below a preset level.

Interest Rate Floors Explained

Interest rate floors and interest rate caps are levels used by varying market participants
to hedge risks associated with floating rate loan products. In both products, the buyer of the
contract seeks to obtain a payout based on a negotiated rate. In the case of an interest rate
floor, the buyer of an interest rate floor contract seeks compensation when the floating rate falls
below the contract’s floor. This buyer is buying protection from lost interest income paid by the
borrower when the floating rate falls.
Interest rate floor contracts are one of three common interest rate derivative contracts, the other
two being interest rate caps and interest rate swaps. Interest rate floor contracts and interest
rate cap contracts are derivative products typically bought on market exchanges similar to put
and call options. Interest rate swaps require two separate entities to agree on the swapping of
an asset, typically involving the exchanging of fixed-rate debt for floating-rate debt. Interest rate
floor and interest rate cap contracts can provide a different alternative to the exchanging of
balance sheet assets in an interest rate swap.

KEY TAKEAWAYS

 Contracts and loan agreements often include interest rate floors.

 Interest rate floors are in contrast to interest rate ceilings or caps.
 There are three common interest rate derivative contracts, with interest rate floors being
just one.
Real World Example of an Interest Rate Floor
As a hypothetical example, assume that a lender is securing a floating rate loan and is looking
for protection against lost income that would arise if interest rates were to decline. Suppose the
lender buys an interest rate floor contract with an interest rate floor of 8%. The floating rate on
the $1 million negotiated loan then falls to 7%. The interest rate floor derivative contract
purchased by the lender results in a payout of $10,000 = (($1 million *.08) - ($1 million*.07)).

The payout to the holder of the contract is also adjusted based on days to maturity or days to
reset which is determined by the details of the contract.

The Use of Floors in Adjustable Rate Loan Contracts

An interest rate floor can also be an agreed upon rate in an adjustable rate loan contract, such
as an adjustable mortgage. The lender’s lending terms structure the contract with an interest
rate floor provision, which means that the rate is adjustable based on the agreed-upon market
rate until it reaches the interest rate floor. A loan with an interest rate floor provision has a
minimum rate that must be paid by the borrower to protect the income for the lender.

Term of Loan
Segal, T. (2019). Term loan definition. Retrieved from
https://www.investopedia.com/terms/t/termloan.asp

What Is a Term Loan?

A term loan is a loan from a bank for a specific amount that has a specified repayment schedule
and either a fixed or floating interest rate. A term loan is often appropriate for an established
small business with sound financial statements. Also, a term loan may require a substantial
down payment to reduce the payment amounts and the total cost of the loan.

Term Loan

How a Term Loan Works

In corporate borrowing, a term loan is usually for equipment, real estate, or working capital paid
off between one and 25 years. Often, a small business uses the cash from a term loan to
purchase fixed assets, such as equipment or a new building for its production process. Some
businesses borrow the cash they need to operate from month to month. Many banks have
established term-loan programs specifically to help companies in this way.

The term loan carries a fixed or variable interest rate—based on a benchmark rate like the U.S.
prime rate or the London InterBank Offered Rate (LIBOR)—a monthly or quarterly repayment
schedule, and a set maturity date. If the loan proceeds are used to finance the purchase of an
asset, the useful life of that asset can impact the repayment schedule. The loan requires
collateral and a rigorous approval process to reduce the risk of default or failure to make
payments. However, term loans generally carry no penalties if they are paid off ahead of
schedule.

KEY TAKEAWAYS

 A term loan is a loan issued by a bank for a fixed amount and fixed repayment schedule
with either a fixed or floating interest rate.
 Companies often use a term loan's proceeds to purchase fixed assets, such as
equipment or a new building for its production process.
 Term loans can be long-term facilities with fixed payments, while short and intermediate-
term loans might require balloon payments.
Types of Term Loans
Term loans come in several varieties, usually reflecting the lifespan of the loan.

 A short-term loan, usually offered to firms that don't qualify for a line of credit, generally
runs less than a year, though it can also refer to a loan of up to 18 months or so.
 An intermediate-term loan generally runs more than one—but less than three—years
and is paid in monthly installments from a company’s cash flow.
 A long-term loan runs for three to 25 years, uses company assets as collateral, and
requires monthly or quarterly payments from profits or cash flow. The loan limits other
financial commitments the company may take on, including other debts, dividends, or
principals’ salaries and can require an amount of profit set aside for loan repayment.

Both intermediate-term loans and shorter long-term loans may also be balloon loans and come
with balloon payments—so-called because the final installment swells or "balloons" into a much
larger amount than any of the previous ones.

While the principal of a term loan is not technically due until maturity, most term loans operate
on a specified schedule requiring a specific payment size at certain intervals.
Example of a Company-Oriented Term Loan
A Small Business Administration loan, officially known as a 7(a) guaranteed loan, encourages
long-term financing. Short-term loans and revolving credit lines are also available to help with a
company’s immediate and cyclical working capital needs. Maturities for long-term loans vary
according to the ability to repay, the purpose of the loan, and the useful life of the financed
asset. Maximum loan maturities are 25 years for real estate, seven years for working capital,
and ten years for most other loans. The borrower repays the loan with monthly principal and
interest payments.
As with any loan, an SBA fixed-rate loan payment remains the same because the interest rate is
constant. Conversely, a variable-rate loan's payment amount can vary since the interest rate
can fluctuate. A lender may establish an SBA loan with interest-only payments during a
company’s startup or expansion phase. As a result, the business has time to generate income
before making full loan payments. Most SBA loans do not allow balloon payments.

The SBA charges the borrower a prepayment fee only if the loan has a maturity of 15 years or
longer. Business and personal assets secure every loan until the recovery value equals the loan
amount or until the borrower has pledged all assets as reasonably available.

Future Amount or Maturity Value

Chen, J. (2019). Future Value (FV). Retrieved from
https://www.investopedia.com/terms/f/futurevalue.asp

What is Future Value (FV)?

Future value (FV) is the value of a current asset at a specified date in the future based on an
assumed rate of growth.

If, based on a guaranteed growth rate, a $10,000 investment made today will be worth $100,000
in 20 years, then the FV of the $10,000 investment is $100,000. The FV equation assumes a
constant rate of growth and a single upfront payment left untouched for the duration of the
investment.

Future Value

Breaking Down Future Value

The FV calculation allows investors to predict, with varying degrees of accuracy, the amount of
profit that can be generated by different investments. The amount of growth generated by
holding a given amount in cash will likely be different than if that same amount were invested in
stocks, so the FV equation is used to compare multiple options.

Determining the FV of an asset can become complicated, depending on the type of asset. In
addition, the FV calculation is based on the assumption of a stable growth rate. If money is
placed in a savings account with a guaranteed interest rate, then the FV is easy to determine
accurately. However, investments in the stock market or other securities with a more
volatile rate of return can present greater difficulty.

For the purposes of understanding the core concept, however, simple and compound interest
rates are the most straightforward examples of the FV calculation.

Future Value Using Simple Annual Interest

The FV calculation can be done one of two ways depending on the type of interest being
earned. If an investment earns simple interest, then the formula is as follows, where I is the
initial investment amount, R is the interest rate and T is the number of years the investment will
be held:

FV = I * [1 + (R * T)]
For example, assume a $1,000 investment is held for five years in a savings account with 10%
simple interest paid annually. In this case, the FV of the $1,000 initial investment is $1,000 * [1 +
(0.10 * 5)], or $1,500.

Future Value Using Compounded Annual Interest

With simple interest, it is assumed that the interest rate is earned only on the initial investment.
With compounded interest, the rate is applied to each period's cumulative account balance. In
the example above, the first year of investment earns 10% * $1,000, or $100, in interest. The
following year, however, the account total is $1,100 rather than $1,000, so to calculate
compounded interest, the 10% interest rate is applied to the full balance for second-year interest
earnings of 10% * $1,100, or $110.

The formula for the FV of an investment earning compounding interest is:

FV = I * [(1 + R)T]

Using the above example, the same $1,000 invested for five years in a savings account with a
10% compounding interest rate would have a FV of $1,000 * [(1 + 0.10)5], or $1,610.51.