Introduction
Finance can seem intimidating, but understanding a few key terms can simplify your journey toward financial literacy. Whether you’re managing personal finances, investing, or planning for the future, grasping these basic terms can empower you to make informed decisions. Let’s break down these concepts with simple definitions and practical examples.
1. Return on Investment (ROI)
ROI measures the profitability of an investment relative to its cost.
Formula:
ROI = (Net Profit / Investment Cost) ×100
Example:
Imagine you invest ₹50,000 in the stock market, and after a year, your investment grows to ₹60,000.
ROI = ( (₹60,000 − ₹50,000) / ₹50,000) × 100 = 20%
A 20% ROI means you earned ₹10,000 on your investment.
2. Compound Interest
Compound interest is the interest earned on both the principal and previously earned interest.
Formula: A = P × (1+r)n
Where:
- A = Total amount
- P = Principal amount
- r = Annual interest rate (in decimal form)
- n = Number of years
Example:
If you invest ₹10,000 at an annual interest rate of 8% for 5 years:
A = ₹10,000 × (1+0.08)5
= ₹10,000 × 1.469
= ₹14,690
You’ll earn ₹4,690 in interest over 5 years.
3. Inflation
Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power.
Example:
If an item costs ₹1,000 today and the inflation rate is 5% annually, in 3 years, the price would be:
Future Price = ₹1,000 × (1+0.05)3
= ₹1,000 × 1.157
= ₹1,157
This means you’d need ₹1,157 to buy the same item in 3 years.
4. Emergency Fund
An emergency fund is a financial safety net for unexpected expenses, typically 3–6 months of living expenses.
Example Calculation:
If your monthly expenses are ₹30,000, you should aim for:
₹30,000 × 6 = ₹1,80,000
This ensures you’re financially secure in case of emergencies.
5. Debt-to-Income Ratio (DTI)
DTI measures the percentage of your income that goes toward paying debts.
Formula: DTI = (Gross Monthly Income / Total Monthly Debt Payments) × 100
Example:
If you earn ₹50,000 monthly and spend ₹15,000 on loan repayments:
DTI = ₹50,000 / ₹15,000 × 100 = 30%
A DTI below 36% is considered manageable.
6. Net Worth
Net worth is the difference between your total assets and liabilities.
Formula: Net Worth = Assets − Liabilities
Example:
If you own a house worth ₹50,00,000 and have a home loan of ₹30,00,000:
Net Worth = ₹50,00,000 − ₹30,00,000 = ₹20,00,000
Conclusion
Understanding these key financial terms is the first step toward mastering your finances. With concepts like ROI, compounding, and inflation, you can make smarter decisions and plan effectively for the future. Start applying these principles today and take control of your financial journey!
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