The cost of money: Why it changes and why that matters to you
The cost of money is due to inflation and other factors. Educated investors need to be very sensitive to the cost of money, as it will guide investment decisions.
- Inflation is the tendency for prices of goods and services to increase over time. Let's say you lend money to a friend for a year. When you get it back, you won't be able to buy the same amount of goods or services you would have been able to buy had you spent it instead. Yet, your friend enjoyed the full value of your dollar.
You should be compensated for the loss of value, right? Interest is the compensation for the loss of value of money over time. It's the cost of money.
Interest is the charge added to the loan that makes up the cost of money, and usually expressed as a percentage of the loan principal, or the original amount of the loan. The interest rate tells you what percentage of the unpaid loan will be charged each period. The period is usually a year, but may be any agreed-upon time.
If interest is not collected each period but allowed to accrue instead, then the accrued interest is added to the principal so that the interest is charged on the preceding periods' interest, as well as the unpaid principal. This is known as compound interest, or the amount of money to be paid on the unpaid balance of a loan, including unpaid principal and interest. When economic forces such as supply and demand affect the amount of money available for investment in the economy, inflation may respond by rising or falling. Stay financially fit, friends.