What is the discount rate?
It is a bridge between time and value
What is the discount rate? Why do we need to understand the concept of discount rate (discount rate)? Understanding discount rates is important for financial analysis and investment decisions . Discount rates help us convert the value of future cash flows into present values, taking into account the impact of time value. Understanding the discount rate can change the way we look at things in the field of financial management, and then make decisions that are more in line with the values of life. Therefore, in the following articles, we will introduce the concept of discount rate, and share common usage scenarios in daily life, so as to make it more flexible.
What is the discount rate?
The discount rate is very important for investment and financial management. Why do we need to understand discount rate? Because in general, we will compare two money values at the same point in time , but when we talk about financial management or investment, we will almost always add the variable of time, because we will evaluate future asset growth, or is the value of different decisions.
For example, if you invest 100,000 yuan now, it will become 200,000 yuan in 10 years; or you want to borrow a 20-year 1 million mortgage from the bank. These examples all include the existence of discount rates.
However, because the value represented by the currency will be different at different times, we have no way to directly compare the amount. For example, 1 million yuan 30 years ago and 1 million yuan now, you will never say that the value they represent is the same. After all, the former may buy a house, but now 1 million yuan may only buy a house. to one m².
So when we want to convert the future cash value into the current cash value , the discount rate is to state the relationship between the two , or in other words, the discount rate is used to express the relationship of monetary value at different times.
Our common PV (Present Value) is called the present value, while the future value FV (Future Value) is the future currency value, and the discount rate is a ratio between the two.
How to calculate the discount rate?
Think about this question: “Is $1 million now worth more than $1 million in 10 years?”
You will intuitively say that the current 1 million yuan is more valuable. If I ask you further why? You will probably answer that because of inflation, the price of goods will become more and more expensive, and the same amount will buy less and less in the future. Therefore, the current 1 million yuan is more valuable.
correct.
Then let’s assume another situation: One day, you said to your son: Son, are you happy that Dad prepared 1 million for you in 10 years? Unexpectedly, the son actually replied: I’m not happy, give me the money now.
As the father of your child, you already know that the value of one million ten years from now is different from the one million now , but in order to satisfy your son’s wishes, how much are you willing to give now?
We all know that the value of currency in different eras is different, and the ratio of currency value converted from the future to the present is called the discount rate .
From the above example, if you later decide to give your son 500,000 yuan, then the calculation of the discount rate is
- Present value (money now) * (1 + discount rate) ^ number of years = future value (money in the future)
- 500,000* (1+discount rate)¹⁰(year) = 1 million
- (1+discount rate)¹⁰ = 2
- Discount rate ~= 7.177%
In other words, when you think that the value of currency depreciates by about 7.177% per year, the current 500,000 yuan will be equivalent to 1 million yuan in 10 years, and 7.177% is the so-called discount rate.
Therefore, the discount rate is a ratio used to illustrate the value exchange relationship between the current currency and the future currency. When the discount rate is higher, it means that the currency value will depreciate faster in the future. For example, if the discount rate is 10%, the current 100 yuan will be equal to 17,449 yuan in 30 years; and when the discount rate is smaller, the depreciation speed will be faster. The slower it is, the discount rate of 1%, the current 100 yuan will be equal to 1347 yuan in 30 years.
The same 100 yuan, in the context of different discount rates, represents a different value.
Application of discount rate
Inflation
The money you save now will lose money in the future . I think inflation is the best example of using it.
The way many people manage their money is to deposit their hard-earned money in the bank. Saving money is a virtue. Before you know how to invest, saving money is indeed the best way to manage your money. However, too conservative investment often makes the hard-earned money lose its original value.
Taiwan’s inflation rate is about 2% in the long run. In other words, prices will rise by an average of 2% every year. We all know that once things become more expensive, but the money in the wallet does not increase accordingly, this is the so-called decline in real purchasing power. thing.
However, in order for us to have the same purchasing power, how much money should we prepare to buy something worth 100 yuan now?
Can apply the previous formula to calculate
- Money now * (1 + discount rate) ^ number of years = money in the future
- 100*1.02¹=102
Through the calculation of the discount rate, next year’s 102 yuan will be equivalent to this year’s 100 yuan. This means that the money is obviously in Taiwan dollars, but the money has become thinner. Next year’s 100 yuan must be two yuan more than this year’s. 100 yuan is the same value.
In other words, if we want to buy a product worth 100 yuan this year next year, we have to prepare 102 yuan, and this is the problem caused by overly conservative investment.
When we just save money this year, it is impossible to turn 100 yuan into 102 yuan for nothing. This is inflation, and the discount rate scenario behind it .
Therefore, once we cannot increase the speed of currency and outperform the speed of inflation, the money we save now is destined to lose money in the future .
In order to solve this problem, what you need to do is invest, not just save money, and indexed investment will be the first choice. .
Insurance
Taiwanese people like to buy insurance policies very much. For example, medical insurance, investment insurance policies or savings insurance are all types of insurance that Chinese people often buy. Although I mentioned the purchase principle of insurance in the book “ Investing for 5 Minutes a Year “ to return it to the essence of insurance, there are still many investment friends who combine insurance with investment and financial management to make the original uncomplicated content complicated. .
Among them, some types of insurance also include guaranteed and non-guaranteed principals. The part I want to emphasize is the so-called guaranteed policy.
His concept is roughly like this, if you do not have any risk transfer during the insurance period, after the end of the policy or the end of life, the premium you paid will be returned, and some may even be higher.
When we first heard it, we felt that the principal repayment insurance was not bad, because they returned the money to us with some guarantee in the middle.
But I must clearly emphasize that the cost of repaying the policy is no longer yours.
But many insurance friends do not realize this. They think that they can get back the original premium they paid, and they are satisfied. But the problem is that the money you get back decades later can no longer be compared with the value of that year.
Moreover, when you think that you can get the insurance content without paying any premium, in fact, the insurance company has already obtained this intangible value through the value of the discount rate. For them, it is purely different The charging method allows you to pay an invisible premium, but you don’t know it .
Therefore, regarding insurance, I always think that insurance should return to the function of personal protection, and it must be remembered that insurance needs to pay costs ( money ) . If you want to have sufficient protection, you should adopt the method of regular insurance + investment and financial management , Deepen your own pocket in the future, I believe it will be a better choice.
financial plan
In daily life, in addition to inflation, investment is also inseparable from the scope of discount rate.
From the previous example of comparing discount rates:
- 10% discount rate: 100 yuan now will be equal to 17449 yuan in 30 years
- 1% discount rate: 100 yuan now will be equal to 1347 yuan in 30 years
We can say that when the discount rate is higher, it means that the value of the currency in the future will be lower and lower. From another perspective, the current currency is very valuable, which is more important.
Especially for debt .
It’s like you borrowed 100 yuan from the bank today, and the bank says that you have to repay 17,449 yuan after 30 years. 10% opportunity cost, which is what the bank thinks the money is discounting at.
However, as long as we grasp two principles, we have the opportunity to reduce our real debt and make use of it.
- Funds discount rate > debt interest rate
- the later the better
First, the discount rate here can be regarded as an opportunity cost. Once you can convert the debt funds into the growth result of the discount rate, this debt will actually bring you a positive capital flow. It’s debt that will make you money.
For example, if you borrow funds with a 1% interest rate, but if in the future, you obtain a 2% capital growth through investment, this is making money.
Therefore, when the discount rate (opportunity cost) you realize for this fund is higher than the interest rate of the debt, the debt is a good debt and will bring positive cash flow.
The second point is that there is another characteristic of debt, which is the timing of repayment. When we exclude the factor of interest, you should understand that if you can choose the time to repay the debt, the later the payment, the better for us .
Why? We can think about it.
If you borrowed 100 yuan from the bank today, and the bank asked you to choose the repayment date in addition to the Buddha’s heart, would you choose to pay it back tomorrow or 10 years later?
When we choose to repay in a farther future, the implication behind it is that we borrow money that will be less valuable in the future and use it as valuable money now .
As I said before, 1 million in 30 years can buy a house. At that time, if you could borrow 1 million from the bank 30 years later, that is, borrow 1 million and pay it back after 30 years. Life would have turned out very differently, right?
Therefore, regarding the debt in financial planning, the category of discount rate is also inseparable. In other words, for those who have debts, the discount rate is a very important point of consideration.
Discount rate conclusion
The concept of discount rate, after the explanation in this article, I believe you must understand that the discount rate is actually closely related to our daily life, especially in the related fields of investment and financial management, because it can be transformed into various interest rates, and it can also be an opportunity cost .
Unless we can stop time, the value of currency will be different as time goes by, and the discount rate is born for this, so that we can have a method to judge the value of currency in different time and space, and it is even more a The bridge between time and value.
However, there is no clearer example of the application of the discount rate than inflation.
In order to maintain the same purchasing power, we must catch up with the inflation rate, whether it is increasing human capital or investing through indexation to continuously increase assets, in order to maintain the same standard of living. But from another point of view, once you have the ability to use the future money for the present, it is the technique of rebirth from the ashes of the currency, which greatly increases its intrinsic value.
Remember, money today will be worth more than it will be in the future.
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