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This section has covered the second half of information about the time value of money. The major goal of this section was to help you better understand the time value of money. This section also helped you understand how inflation impacts your investments.

An annuity is a series of equal payments that a financial institution makes to an investor at the end of each period (usually a month or a year) for a specific number of years. A compound annuity is a type of investment in which a set sum of money is deposited into an investment vehicle at the end of each year for a specific number of years and allowed to grow. Annuities are important because they can help you prepare for retirement and allow you to receive a specific payment every period for a number of years. You can calculate both the present value of an annuity and the future value of an annuity.

An amortized loan is a loan that is paid off in equal installments (payments) that are made up of both principal and interest. With an amortized loan, the interest payments decrease as your outstanding principal decreases; therefore, with each payment, you pay a larger amount on the principal of the loan. Examples of amortized loans include car loans and home mortgages.

Inflation is an increase in the volume of available money in relation to the volume of available goods and services; inflation results in a continual rise in the price of various goods and services. In other words, because of inflation, you can buy fewer goods and services with your money today than you could have bought in the past.

A real return is the rate of return you receive after the impact of inflation. As discussed earlier, inflation has a negative impact on your investments because your money will be able to buy less in the future. Traditionally, investors have calculated real returns with the approximation method by simply using the nominal return, or the return you receive, minus the inflation rate. Although the approximation method is fairly accurate, it can give incorrect answers when it is used for precise financial calculations. Because of the possibility of error, it is preferable to use the exact formula: (1 + nominal return (rn)) = (1 + real return (rr)) * (1 + inflation (π)) = (1 + nominal return (rn)) / (1 + inflation (π)) –1.


Now that you have completed this section, ask yourself the following questions:

  1. Can I solve problems related to annuities?
  2. Can I solve problems related to amortized loans?
  3. Can I explain how inflation impacts my investments?
  4. Can I calculate real returns after inflation?


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