by James Burton
Today we are going to examine the “time value” of your money. The entire essence of this value can be summed up in one sentence:
“A dollar today is worth more than a dollar at some time in the future.”
At first glance, this idea may not appear to ring true, since the cash we have today holds the same value next month if we don’t spend it. The key to understanding this concept is to accept that the cash we have today could be loaned to the bank with interest, or invested in bonds or stocks. Therefore, cash today is worth more, even if only hypothetically, than cash at some point in the future.
Suppose you invest $1,000 in a 5% annual-interest bearing savings account today. It will be worth $1,050 in one year. Therefore, if I am forced to choose between $1,000 today or $1,000 one year from now, I should obviously choose to get the money now since in one year it could be worth $50 more than then the same $1,000 a year from now. By saving the $1,000 today, you let the time value of money work for you.
Keep in mind however, the time value of money can work against you. To see this, reverse the previous example. Suppose that instead of receiving $1,000 today, you spent $1,000 today with a credit card and agree to pay back the money in one year. Recall that a dollar today is worth more than a dollar at some time in the future, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today).
Remember, this is a cost on top of the interest you agree to pay the credit card company for loaning you the money. So, assuming a 15% annual interest rate, the true costs of charging the $1,000 today are the $150 you pay in interest plus the opportunity cost of not earning the $50 you could have by putting the money in a savings account for a year. In other words, you are actually paying 20% interest by letting the time value of your money work against you that long.
The implications of this concept are at the root of deciding where to place your money in the future. When considering where to invest your money over a long period of time, you always have to take into account the opportunity cost of where you could be placing you money when you place it elsewhere. In other words, you have to take into account the opportunity cost of your investment. Taking into account the time value of your money is a critical step in correctly evaluating the opportunity cost of your investment.
For example, suppose you borrowed $20,000 to purchase a car, and the loan had a 10% interest rate (for five years). Your monthly payments would be $424.94. Because the $20,000 loan continues to compound over the life of the loan, you actually pay $25,496.45 over the five-year period, meaning that you’ve paid $5,496.45 extra because you spent the money before you had it. In this case, the bank or lender that gave you the loan uses the time value of money to their advantage.
Now reverse the scenario. Instead of making the $424.94 car payment, you invest that payment at the same rate as what your car loan was (granted, it’s a little high for a savings rate, but not unreasonable for other investments.) Now, instead of paying the bank, you are actually earning interest and compounding the benefit yourself. After one year, you will have saved $5,340 and earned $240 in interest. After two years, you will have saved $11,239 and earned $1,039 in interest. By the third year, your investments will be worth almost $18,000 and you will have earned $2,457 in interest. By month 40, you will have enough money to purchase a $20,000 car in cash.
In the first case, you paid the bank $5,496 to borrow the money, and in the second case, you earned $2,457 and could buy the car in cash after just 40 months (just over three years)! The opportunity cost of the first alternative versus the second is a net difference of $7,953 (a $2,457 gain versus a $5,496 loss). That means that by making a simple deferral decision (buying the car in three years versus today), you can get ahead by almost $8,000! Taking such time value effects into consideration will help you make the most of your money and assure that you make the right investment decisions.