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Understand How Money Works

What is Money?

Money is a medium of exchange; which allows people to obtain what they need. So, the value of money is based on what it can be exchanged for. Perhaps you have heard people who joke that US money is a “paper with headshots of dead presidents”. If you stash that money under your bed for years, it won’t get you any values and won’t grow. But if you exchange it for the things you need in life, you get some values out of it. If you invest it, then the value of what it can buy may increase over time.

Six Characteristics of Money:

  1. Money is durable: It can be used over and over again.
  2. Portable: It must be able to be transported as people travel.
  3. Divisible: It allows for different denominations.
  4. Uniform: It is standardized so that it looks same.
  5. Limited: It exists in limited supply.
  6. Acceptable: It is acceptable for the value that people receive. 

How Does Money Multiply (Making Your Money Work for You)

Money is only a tool and won’t multiply (grow) if we don’t invest it. Money grows exponentially over time rather than just incrementally.  For this reason, the earlier you invest it, the greater the level of growth that your money enjoys. Let’s look at how money multiples.

Compound Interest:

The best form of financial growth is by Compound Interest. This is the interest on a loan or deposit calculated based on both the initial principal and the accumulated interest from previous periods.

Assume that you invest $1,000 once and get returns of 35% every year.  What will be the value of your money after 25 years if you keep reinvesting the returns instead of spending them? Most people try to guess the answer by calculating 35% of $1,000 and multiplying it by 25 years (which gives $8,750); rather the answer is $1.8 million, because of compound interest.

Rule of 72

The Rule of 72 is a simple way to determine how long an investment will take to double at a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can roughly estimate how many years it will take for the initial investment to double itself. This rule states, “If you divide 72 by the rate of return, you get the number of years that it will take for your money to double”.

For example, if your money earns 35% interest, it takes 2 years for your money to double, but at 12% interest it will take 6 years for your money to double, and so forth.  Money really does GROW when it is wisely invested.

How Money Can Lose Value

Money can lose value through:

Inflation: Inflation is the general increase in prices and fall in the purchasing value of money. It reduces what the same amount of money can purchase over time.  For example, one may need $1,000 today to buy a computer. However, one year later, the price of that same computer increases to $1,200.  In other words, $1,000 today has the same purchasing power as $1,200 one year later.

Theft and Destruction: Money that is not invested can either be stolen, destroyed by fire or flood and totally lost.

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