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Step by Step Guide How to Calculate Future Value for Your Investments

31 Jul 2023

Introduction

You may be familiar with the famous saying, "A rupee today is worth more than a rupee tomorrow." This statement highlights the concept of the time value of money, indicating that money's worth fluctuates over time due to factors like inflation, interest rates, and opportunity costs. Consequently, when planning for your future financial objectives, such as retirement, education, or purchasing a house, it becomes essential to understand the actual worth of your money in the forthcoming years. This is where the concept of future value proves to be a valuable tool.

What is Future Value?

Future value (FV) is the amount of money that a current investment or asset will grow to at a specific date in the future, assuming a certain rate of return. By calculating the future value of your investments, you can estimate how much you need to save and invest today to achieve your desired future outcome. You can compare various investment options and select the one that promises the greatest future value for your money.

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How to Calculate Future Value?

You have two methods to calculate the future value of your investment: the simple interest formula and the compound interest formula. Let's understand each future value formula separately.

Future Value Using Simple Interest

Simple interest is the interest calculated only on the initial principal amount of an investment or loan. It does not consider the interest earned or paid on the accumulated interest over time. The formula for calculating the future value using simple interest is:

FV = PV * (1 + r * n)

Where:

  • PV = Present value or initial principal amount
  • r = Interest rate per period (expressed as a decimal)
  • n = Number of periods

Suppose you put Rs 1,000 in a savings account with a 5% annual interest rate. Using the above formula, your money after 10 years will be:

FV = Rs 1,000 * (1 + 0.05 * 10)

FV = Rs 1,000 * (1 + 0.5)

FV = Rs 1,000 * 1.5

Future value of your money after 10 years = Rs 1,400

Here, you can see that the future value is simply the sum of the initial principal and the total interest earned over 10 years.

Future Value Using Compound Interest

Compound interest refers to the interest computed not only on the original principal amount but also on the previously accumulated interest of an investment or loan. It considers the effect of compounding, which means that the interest earned or paid in each period is added to the principal amount and becomes part of the next period's calculation. The formula for calculating the future value using compound interest is:

FV = PV * (1 + r) ^ n

Suppose you put Rs 1,000 in a savings account for 10 years that pays 5% interest compounded annually. The future value of your investment after 10 years will be:

FV = Rs 1,000 * (1 + 0.05) ^ 10

FV = Rs 1,000 * (1.05) ^ 10

FV = Rs 1,000 * 1.629

FV = Rs 1,629

Because of the compounding effect, you can see that the future value is higher than the simple interest case. The difference between the two methods increases as the interest rate and/or the number of periods increases.

How to Calculate Future Value of Annuity?

For computing the future value of an annuity, which represents a sequence of uniform payments made at regular intervals, you can employ the following formula:

FV = PMT * [(1 + r) ^ n - 1] / r

Where:

PMT = Payment amount per period

For example, suppose you deposit Rs 100 monthly in a savings account for 5 years that pays 6% annual interest compounded monthly. You want to know how much your savings will be worth in 5 years. Here is the calculation:

FV = Rs 100 * [(1 + 0.06 / 12) ^ (5 * 12) - 1] / (0.06 / 12)

FV = Rs 100 * [(1.005) ^ 60 - 1] / 0.005

FV = Rs 100 * [1.348 - 1] / 0.005

FV = Rs 100 * 0.348 / 0.005

FV = Rs 6,960

This means that after 5 years, your savings will be worth Rs 6,960.

Drawbacks of Future Value

While future value calculation formulas offer numerous advantages, they also come with several drawbacks, which include:

  • It does not account for inflation, which can reduce the purchasing power of money over time.
  • It does not account for fluctuating interest rates, which can affect the actual growth rate of an asset or cash.
  • It does not account for currency risk, which can affect the value of an asset or cash in different countries.

Conclusion

Future value is a valuable tool in financial planning, enabling you to estimate the potential worth of your investments or savings in the future. However, it is crucial to exercise caution and realism when using it. Future value calculations are based on certain assumptions, such as a specific rate of return and compounding periods, which may not always hold in the real world.

 

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