Concept of future value
The value of a present amount, for example, RM100 in the future is found by compounding interest over a period of time. When we speak of compound interest, what we mean is that the amount earned on a given deposit (the “interest”) becomes part of the principal amount at the end of the specified period. This principal amount is the money on which subsequent interest will be paid. Contrast this with simple interest, where the interest is only paid on the principal amount alone.

Illustrative examples
A principal amount of RM100 is deposited in a bank account earning 8% per annum for 2 years.

Simple interest: The total interest on RM100 at end of 2 years would be RM16, that is, RM8 at the end of year one plus RM8 at end of year 2. Hence, the future value of RM100 at the end of the first year would be RM108, and RM116 at the end of the second year.

Compounded interest: The total interest earned at end of 2 years would be RM16.64 that is RM8 at end of year one, plus RM8.64 in year two. The difference in the interest for the second year is because the 8% interest is charged on both principal (RM100) and the interest earned in the first year (RM8). Hence, the future value of RM100 would be RM116.64, if compound interest is applied.

Given this scenario, it is not difficult to understand why a small investment today can translate to a substantial return in the future, given the power of compound interest, and time. The general equation that can be used to determine the future value of a particular sum at the end of a specific period is:

= PV x (1 + r)ⁿ

Where,

From our example above, the future value is calculated as:

FV = RM100 x (1 + 0.08)2 = RM100 x 1.1664 = RM116.64.