We have already learnt that capital markets reward people for making sacrifices. People who choose to save the money get paid by the capital markets in the form of dividends and capital gains. However, the time duration for which you want to invest your money is also important. Someone, who is willing to invest for 1 year must be compensated less than someone, who is willing to invest for 4 years. This is taken care by ‘time value of money’ as it uses compound interest.
Let’s consider the case of 2 people investing $100. One has the time horizon of 1 year, while the other has the time horizon of 4 years. Here is what will happen if a 5% simple interest was being considered.
• Investor 1 (Today): $100
• Investor 1 (4 years later): $120
On the other hand:
• Investor 2 (Today): $100
• Investor 2 (1 year later): $105
• Investor 2 (2 years later): $110.25
• Investor 2 (3 years later): $115.77
• Investor 2 (4 years later): $121.56
Therefore, Investor 2 is clearly better off in this case. This is because, not only can he reconsiders his decision whether he wants to lend money each year (less risk); he gets compensated $1.56 more. This discrepancy arises as compound interest was not used.
This is why banks and all financial intuitions quote compound interest rates. Not charging compound interest is a clear cut loss to the lender. However, we also know that these are just nominal values since the first principle states that a dollar today is more valuable than a dollar tomorrow, hence they are both not the same. The real value of money is determined by discounting after you have reached the nominal value using compounding.