Three ways to interpret interest rates

Let’s think you have just saved $100 from your salary. In your brain, you have two alternatives for using the money:

The first one is that: you have been wanting a pair of shoes for some time although you have lots of shoes. So, you can buy those shoes.

Alternatively, you may invest the money for one year into an interest-giving saving account.

The interest rate is currently 5 %, which does not satisfy you.

Thus you decide to buy those shoes.

On the other hand, you would put your money into the saving account if the interest rate was 8 %.

This example illustrates that the required rate of return, which can postpone your current consumption, is 8 %.

By buying the shoes, you have foregone earning $5 at the end of 365 days. This is called the opportunity cost.

The other day, your little brother envied your shoes and wanted you to buy the same shoes with a smaller size for him. Unfortunately, you had no money left, but your boss promised to award you a $105 bonus in one year. So you decided to talk with your boss to persuade him to give the award right now. And your boss said that the present value of $105 in one year is equal to today’s $100, knowing that the yearly discount rate (which is similar to the annual interest rate) is 5 % from above, using the below formula:

Thanks to financial mathematics, you had the money and bought your little brother the shoes!