Understanding Base Rates of Interest and Value of Money - Research Proposal Example

Advanced Financial Planning Dear You may be wondering what is there in the store for you in this letter. Believe me; it has nothing to do with your current curriculum. You will find something the most fascinating, something the most alluring information that everybody wishes to know about but very few get a chance to know. This is all about the topic that the whole world moves around throughout their life; even you wish, you cannot move away from it. That is needed by everybody at anytime. It fulfills all your needs day in and day out. Could you guess what is it that I am talking about? Yes, many of you could identify it correctly. It is money, finance or wealth – whatever you call it. At times, you must have felt that you need to know a lot on the nuances of money – that how it grows or multiplies, or once you have how to safeguard it. Banks and institutions talk about the words such as annuity, mortgage, present value, credit report, bond, stock and hosts of many words of the financial world and you surely know that it is all about money. In order to understand these words completely, you need to grasp these terminologies in its true sense so that you become capable of taking decision on your own. In next few pages, you will sail through the journey of the most fascinating financial world, which when understood fully may help you immensely. Let us begin with some of the very simple and most important terminologies that we must know them in our full grasp. Interest Everyone has heard this word and knows about it. It simply means that money fetches money. The rate at which it fetches is known as interest. The rate is measured in percentage. Surely, higher the rate, larger the benefit flows to you. Understanding Effective and Nominal Interest Rates Let us understand the difference between actual and nominal interest rate. Supposing your credit card company charges you interest of 2.5% per month. That means that nominal interest per year is 30 percent; however, effective interest rate is something else and can be calculated as, Effective interest rate= (1+ i/n)n -1 (Effective and Nominal…) Where, i is nominal interest per year and n is number of periods of compounding. In our case, i=30% or 0.30 and n=12 Effective interest rate= (1+0.3/12)12 -1= (1.025)12 -1 =1.378-1=37.8% It means that though the company informs you about charging 30 percent nominal interest; in real terms, they are charging you at the rate of 37.8 percent. Compounding This is also known by most but understood and grasped by few. Compounding of the money is the most fascinating phenomena that bring enormous benefit to you. Do you know that the compounding has a very important dimension in terms of time? Effect of the money fetching money increases manifold when it works for a longer time. The biggest hurdle that haunts most of the people in the life when they start investment is its smallness. Every big thing initially starts small. The time, energy, and efforts put at the beginning do not seem to justify small returns that any business or investment may offer. People get first thought in the mind "For such a small return should I devote my time and spare the money, which otherwise can better be utilized to get more enjoyment in life." Quick answer surfaces, "Sacrifices are manifold compared to the benefits." The thought of this kind wins over the future benefits that may accrue after a few years. Thus, the person tends to postpone a small but a significant beginning, which is capable of transforming his or her fortune. This issue has to be understood thoroughly before it really happens with you stopping your small beginning for big gains in the future. The point to be noted here is that every tycoon or for that matter every big investor always starts small-- as small as you can ever think of but with the passage of time and their perseverance they become big. I am reminded of an ancient story, which I cannot resist sharing with you. Once there lived a painter who fell upon such tough times that he was unable to earn enough to feed his family. Hearing the generosity of king that he always encouraged talent, the painter decided to show his latest paintings. When brought before the king, he bowed low and presented his finest paintings to the king. Seeing his amazing work, the king patted him at his back and asked him to name his reward. Pointing to a finely crafted chess board, the painter said “Your highness, if you are really pleased, give me just one penny on the first square of this chess board, and double it for every square only until 32 squares as that is my age. If you could kindly do that I will consider myself greatly rewarded.” “Is that all?” asked the king, highly amazed. “Only a penny for the first square to begin with?” King told him that he thought of granting a plate of gold to him. Painter humbly repeated his earlier demand. “So it be that way” ordered the king and his courtiers started placing the pence on the chess board. All went fine till a few squares. The total number of penny on the first ten squares went like –1 + 2 + 4 + 8 + 16 + 32 + 64 + 128 + 256 + 512 and then at 32nd square reached to 2,147,483,648, for a total of exactly 2n-1 = 4,294,967,295 pence, or about 4.3 billion pounds. King instantly realized the financial grasp of the painter; becoming happy he offered him a finance stewardship in his kingdom. This is all about amazing ‘power of compounding.’ If you replicate above phenomena in your life by symbolizing each square as a year of your life and you stay invested; it rises exponentially after a few years even if you could garner a rate of return only 10 percent per annum. Moral of the story is that if you start investing a small part early in your life, how greatly you can be rewarded after some time in your life when you will be retiring. Time exerts the greatest influence on your investment than any other force. Time Value of Money Do you know value of money keeps falling overtime? Pound in 2011 does not fetch the same groceries or goods as Pound in 1960 used to do. In other words, pound has diminished in its purchasing power. Why it so happens? The phenomenon of inflation causes this. What is the inflation then? When prices of commodities go up, the purchasing power of the currency (read pound) diminishes. In economics, this is known as inflation. In other words, pound of tomorrow will be worth less pound of today. This phenomenon helps understand many financial investment concepts to decide about the most beneficial and rewarding investment. The core concept is that we must know and aware about the time value of money. Knowing present value of money helps compare two different streams of cash flows that incur at different time intervals and at different rates in future. Let us assume an investment company offers you £6,000 after 6 years for your investment of £1,000 and another company offers you £3000 after 3 years for the same investment, which one you would go for? Let us assume that money is compounded annually. Formula is (1+i)n = FV/PV (Present Value, Future Value) Where, PV = Present Value FV = Future Value n= the number of compounding periods i = the interest rate per period Calculating, for the first company, (1+i)n = FV/PV= 6000/1000 Or (1+i)6 = 6 Or i = 1.348-1= 0.348 or 34.8 percent (Nth root…) Calculating, for the second company, (1+i)n = FV/PV=3000/1000 Or i=1.442-1 or 0.442 or 44.2 percent From this it is very clear that second company provides return of 44.2 percent per annum compared to only 34.8 per cent of first one. All other things remaining equal, one can go ahead investing in the second company. Above is the example of comparing interest rates for our decision. The concept can also be used by deriving present value of the stream of cash flows of two different annuity proposals. Annuity An annuity is a payment made regularly at fixed interval of time such as yearly, monthly or weekly. Usually, this happens with superannuation or pension payment that person keeps on receiving at fixed duration as agreed upon. Two different annuities can be compared by calculating its present value Taking simple example in which the company ABC offers lump sum value of £5,000 after 6 years for the par value of bond worth £1,000 purchased today and XYZ Company offers £4,000 after 4 years for the same denomination of the bond purchased on the same date and we want to know which one is more lucrative so that one can take decision for investment. Answer to this, lies in calculating present value of the offerings. The one which shows higher present value will be obviously more rewarding. For this, we need to assume fixed rate of discounting or interest rate of 10 percent. The present value of the bond of XYZ Company will be PV= FV/(1+i)n (Present Value…) = 5,000/ (1+0.01)6 = £2,823 In second case, for the company XYZ, it can be calculated as PV= 4,000/ (1+0.01)4 = £2,732 It can be noted from the above that the present value in case of the first company is higher compared to the second company. Certainly, anybody would like to go for first company for the investment provided all other things remain the same. Present value has many applications in our life when we are stuck at some financial decision. Understanding Base Rates of Interest The rate at which the Bank of England, a central bank lends money to other institutions is called base rate and is also set time to time by the Monetary Policy Committee based on the economic conditions. This indicates minimum rate of interest on a loan. Credit Cards Credit card is nearly a necessity these days. It is difficult to meet emergency needs or having a mobile phone or any online purchases. Banks provide facility of credit cards to their customers through which they can shop anytime anywhere. The one that charges you the lowest interest on your outstanding balance is the most sought after card. You need to choose the card based on your necessities. You need to check first the APR called the annual percentage rate. This is the percentage of your balance that you need to pay in interest. The low interest credit card means a credit card with an APR lower than the rates charged by most credit cards. It is a fact that interest rate on credit cards is always higher than charged on most other type loans. The credit cards carry interest rates between 12% and 20% and if you make late payments the rate can go further as high as 29%. The credit history also is a factor that decides about interest rates. Issuing Card Company will decide about your interest rate that will be charged to you. Higher the credit score, the lower is the interest rate. (With So Many Credit…) In the event of poor credit history, you can choose a Bad Credit Credit Card that is designed for those who have less than perfect credit. Certain banks do offer these cards not out of goodness but they will charge higher interest rates on the balance and will allow low spending limits until you prove them that you can display discipline credit behavior. (Credit Builder…) MORTGAGES Once you come out from the university and settle in your job, it is obvious to have a desire owning your own house. Banks and financial institutions are always eager to provide you loan and they have various mortgage products to fulfill your desire. Usually, kind of mortgage products that are offered in the market can be describes as per the following. Fixed Rate Mortgage As name implies, it is a fixed rate mortgage regardless of the future interest rates in the market during the entire tenure of mortgage. Discount Mortgage Repayments go up and down as per the variable rate of the bank. Banks charge rate of interest over the basic rate of interest declared by Bank of England time to time. Tracker Mortgage In this type of mortgage, the interest rate is decided at the rate above the Bank of England Base Rate. As per the variation in the base rate, mortgage rate will also keep falling in line with that. (Tracker Mortgages) Salient Features of the Above Mention Mortgages Feature Fixed Rate Tracker Discount Interest Type Fixed Variable Variable Is interest calculated Daily? Yes Yes Yes Unlimited payments allowed without incurring a charge? (When you make one-off payment to reduce the outstanding balance on your mortgage) No Yes No Is there an early repayment charge? (If you close your mortgage deal, by paying it back early or moving to a different lender. Then you need to pay an Early Repayment Charge) Yes No Yes Can you port your loan if you move home? If you buy new property and sell previous one, you can port your loan from one property to other. Yes Yes Yes (Our mortgages…) Source: https://mortgages.hsbc.co.uk/help/mortgages-explained/types/ How much you can borrow? Your borrowing limit will depend upon several factors such as: 1. How many dependents do you have? 2. The location of the property such as Northern Ireland, Scotland, Wales, London etc. 3. It will also depend on whether you are a first time buyer or remortgaging or moving home. 4. Your age and annual income before tax. The maximum loan you can get will not exceed 90 percent of the value of the property. The maximum period allowed to pay the loan usually is 30 years. Important Terms Frequently Used in Mortgage Loan to Value (LTV) The loan to value means the percentage of the value of the property that any borrower will seek as loan from the lender. E.g. a £100K property with a loan amount of £90K indicates 90% LTV. Booking Fee While securing a particular mortgage deal, a non-refundable fee charged on some mortgages is known as booking fee. Equity Property’s actual value minus the mortgage held is called Equity. Interest Calculated Daily Interest applicable on the remaining mortgage balance is calculated on daily basis rather than at the end of month, weak or year. Remortgage Transferring mortgage from one lender to another is called remortgage. Switching Moving from one type of mortgage to another with the same lender is called switching. Standard Valuation Report Standard Valuation Report finds the correct market value that helps lender determine the amount of advance on mortgage. KFI (Key Facts Illustration) All lenders are required to set out the details for all their products and fees in the same format so that customers can easily compare them. (Jargon-buster) INSURANCE Insurance is another product that is offered by banking sector to meet the varied needs of a person from life insurance, to medical insurance and from home insurance to accident insurance. Life insurance is the most widely used product in insurance sector. Our attempt here will be to understand the basics of insurance. Life Insurance/Assurance Life cover is important as in case of bread earners death, it helps pay off the liability of mortgage payments and keeps family from suffering. A policy that pays agreed lump sum amount on the death of insured person based on the policy conditions. Term Assurance Life insurance built for a fixed number of years with a lump sum payment payable if the life insured die during the terms of policy. Difference between Life Insurance and Life Assurance Both terms are mostly used interchangeably. The term assurance is used for the event that is certain to happen such as death. The term insurance is used to denote an event that might happen. (Life Insurance…) Whole Life Protection Plan It is obvious that everyone wants to provide security to the family in case of some untoward incident happens to the person. Whole life plan fulfills the need of life insurance and provides the lump sum to the nearest of kith and kin in the event of death of insured person. It provides for flexible payment options of making just a single payment as premium or if needed one can choose to pay for any number of years until 65 or even more. Investment-type Life Insurance Investment-type Life Insurance policy depend upon the performance of the insurance fund over time and that is the reason they are risky than simple life insurance policy. (WholeLife Protection…) Health Insurance These kinds of policies will have all treatment costs covered as per the contractual agreed terms and conditions. In case of long-term illness, the loss of income also gets paid through such insurance policies. (Health Insurance…) Retirement Annuity Plan After working hard throughout life, one wishes for secure and comfortable retirement. With good medical facilities and improved standards in life average age of the people in U.K has gone up. Mandatory Provident Fund is a good way of preparation for retirement fund; however everyone needs more fund to live peacefully after retirement. The other way to supplement the income after retirement is good annuity plan that give fixed monthly return after retirement. The annuity plan is designed to build savings to be used after your retirement. Your accumulation period could be period as chosen by you or until your retirement age. At the end of the accumulation period, either you start receiving annuity – monthly or yearly payments as agreed by you or a lump sum payment as per the option selected by you. In annuity options, you can get your retirement savings in form of: stream of monthly annuity payments or cash lump sum if you so desire or You can further accumulate your annuity payments, if you wish, with interest until the end of annuity period. The annuity plan also provides disability or unemployment benefits ensuring that your policy continues even though you are not in the position to pay premium for some criticality or misfortune at your end. (RetireIncome Annuity…) Mutual Funds It is very difficult for small investors to pick the stock for investment. You can see hundreds of stocks listed in the market and yet finding one which will appreciate remarkably is a daunting task. Mutual funds come into picture here. You can invest into any reputed mutual funds, who in turn invest in highly diversified portfolio to safeguard the investments. You get the benefit of experts hand for investment. Thus, you get invested in multiple shares through mutual fund. This reduces your risk substantially. The advantages in investing mutual funds can be listed as per the following 1. Diversification Diversification is a key for success in stock market. Same is achieved by investing in a mutual fund as they invest and have typically highly diversified portfolio. Small investor investing directly in the market takes huge risk for if you have invested your funds in two or three stocks and if all go bust, you lose all of your hard earned savings. In mutual fund, fund manager invests funds in large number of shares spreading it in more than 50 shares. Investment in a single share never exceeds 2-3 percent. Inherent risk element of investing in stock market is thus minimized to a great level by spreading investment across wide spectrum of sectors and within the sectors across multiple companies. An investor with a small fund cannot implement such a strategy; that is the why people prefer the vehicle of mutual fund to invest in the stock market. 2. Lower Cost Low cost of transaction is another reason for small investors to go for mutual fund. The cost of commissions for small investor investing small amount is quite high, which is taken care at mutual fund for they have huge fund to invest. Moreover, a fee charged by mutual fund to small investor is a tiny amount. 3. Professionalism Mutual funds are established and managed by qualified and professional people so you get benefit of their expertise and full professionalism in their day to day operations. You need to simply find an ethical and good professional mutual fund to invest your surplus fund. Mutual fund investment is usually done keeping in mind investment horizon of several years so invest your funds in mutual fund only when you can spare it for 7-10 years or more. (Stocks and Mutual …) Bonds If you are risk averse investing in stock market, you can go for a safer investment in the instruments like company bonds. In company bonds, you give loan to the company at some fixed interest rate for fixed period of time. Bonds can provide you consistent return safeguarding your initial capital. When you are young and capable of taking risk you can go for more stock investing and as you cross middle age and become risk averse, you can go for bond or any other fixed return security. A typical mix between stock and bond can be formulated as per your age profile. Always remember that in stock you have chance of enormous appreciation and depreciation both but in bond you have fixed agreed return per annum. (Difference between …) And finally summing up, I hope you enjoyed the journey that this paper sailed you through some of the financial nuances and the terms that touch life of everyone. In fact, our life moves around finance and in this ever expanding world of science and technology whether you are working as an engineer or doctor or deployed somewhere in a fast moving Information Technology Company–you will always have concerns with such terms. Every one of you, regardless of your field of operations, you need to buy some day life insurance or health coverage, buy a house on mortgage, use credit card for your daily needs, or investing in bond, stocks or mutual fund products; you ought to have clear understanding as to how your money will grow in the long run. Although, we do take help of experts in our daily life for the things that we do not know yet it becomes necessary in this competitive world to have basic understanding of these matters. You can’t discuss the subject with experts until and unless you understand the fundamentals of it so do not leave everything on experts and take your own decision after discussing with them. Do remember that the list of products that we have discussed in this paper is not exhaustive and as you progress in your life, you will come across many such products that may be of interest to you. If you have any questions, please do write to us. References: 1. Effective and Nominal Interest Rates [Online] available at http://www.travismorien.com/FAQ/tvm/effectivevsnominalir.htm [Accessed 7 May 2011] 2. Nth root calculator [Online] available at http://www.basic-mathematics.com/nth-root-calculator.html [Accessed 7 May 2011] 3. Present Value, Future Value [Online] available at http://accountinginfo.com/study/pv/pv-factor-01.pdf [Accessed 7 May 2011] 4. Present Value Calculator. [Online] available at http://www.moneychimp.com/calculator/present_value_calculator.htm [Accessed 7 May 2011] 5. With So Many Credit Cards Available, How Do You Choose? [Online] available at http://www.airaid.co.uk/guides/credit-cards/how-do-you-choose-which-credit-card.html [Accessed 7 May 2011] 6. Credit Builder Credit Cards. [Online] available at http://www.uswitch.com/credit-cards/bad-credit-credit-cards/ [Accessed 7 May 2011] 7. Tracker Mortgages. [Online] available at https://mortgages.hsbc.co.uk/help/mortgages-explained/tracker/ [Accessed 7 May 2011] 8. Our mortgages explained. [Online] available at https://mortgages.hsbc.co.uk/help/mortgages-explained/types/ [Accessed 7 May 2011] 9. Jargon-buster. [Online] available at https://mortgages.hsbc.co.uk/jargon-buster/ [Accessed 7 May 2011] 10. WholeLife Protection Plan. [Online] available at http://www.hfi.hsbc.com.hk/data/hk/invest/unit/ut_fs_wlpp_en.pdf [Accessed 7 May 2011] 11. Life Insurance FAQs [Online] available at http://www.barclays.co.uk/Helpsupport/LifeinsuranceFAQs/P1242584592819 [Accessed 7 May 2011] 12. Health insurance - what its all about. [Online] available at http://www.barclays.co.uk/Helpsupport/Healthinsurancewhatitsallabout/P1242573502995 [Accessed 7 May 2011] 13. RetireIncome Annuity Plan. [Online] available at http://www.hfi.hsbc.com.hk/data/hk/invest/unit/ut_fs_riap_en.pdf [Accessed 7 May 2011] 14. Stocks and Mutual Funds. [Online] available at http://www.stocktrader.org.uk/stock-and-mutual-funds.html [Accessed 7 May 2011] 15. Difference between Stocks and Bonds. [Online] available at http://www.stocktrader.org.uk/difference-between-stocks-and-bonds.html [Accessed 7 May 2011] Part B (100 Words on Three Sites) 1. RetireIncome Annuity Plan. [Online] available at http://www.hfi.hsbc.com.hk/data/hk/invest/unit/ut_fs_riap_en.pdf The site pertains to annuity. It gives a good idea how savings accumulated over a period can get compounded in large sums. Schemes give life cover along with accumulated dividends. The scheme give unemployment and terminal illness benefit before the age of 65. Premium payments can last as many years as one desires until the age 55; these are also called accumulation period. Death or dismemberment as a result of accident before age 65 makes eligible for additional sum. Plan also envisages paying cash sum for any critical illness before age 65. 2. Stocks and Mutual Funds. [Online] available at http://www.stocktrader.org.uk/stock-and-mutual-funds.html [Accessed 7 May 2011] Other than mutual fund details, the site also explains about stock market basics. The site gives good information about fundamental and technical analysis of the market. It also provides tools for fundamental analysis. It also discusses in detail about technical analysis indicators and patterns. Stock index and stock options are explained in a plausible manner. Those with research bent of mind will get clue regarding how to research stocks. Moreover, site speaks a lot about many other aspects of stock market. 3. Our mortgages explained. [Online] available at https://mortgages.hsbc.co.uk/help/mortgages-explained/types/ The site gives various mortgage products currently available with the bank. The products are from 2 year fixed special to 5 year fixed special products with maximum loan to valuation of 90 percent. The interest rate applicable is 6.29%. It permits overpayment up to 20 percent of standard monthly charge. It carries a portable benefit with them. Repayments are for the fixed duration and at fixed rates regardless of what happens to the market interest rates. In fact, site carries numerous mortgage products with all necessary terms and conditions mentioned along with fees applicable. Read More