The Concept of Time Value of Money Is Important in Making Financial Decisions Because …
“A bird in the hand is worth two in the bush”
This medieval proverb is still valid today. In modern terms, it is better to have a certain profit today than an uncertain one in the future. After all, who knows what the future holds? By understanding the importance of time value of money (TVM), you can find out how to hack the concept of TVM to your advantage.
What is TVM? Time Value Money Real Life Example
What if someone gave you $10,000 today or $10,000 in three years?
Of course you will take $10,000 today. In fact, $10,000 earned today is worth more than $10,000 earned in three years because:
You don’t know if inflation will hurt the purchasing power of $10,000.
You can invest that $10,000 to make more money. Therefore, if invested wisely, you will have more than $10,000 in three years.
This example is a “no brainer”. But what if someone offered you $10,000 today or $12,000 in three years, which would you choose?
The answer is, it depends. It depends on what profit or interest you can get on that $10,000 over the next three years. This is where smart financial speculation begins.
Why Is Time Money Important?
Imagine you could have $10,000 today or $12,000 in three years. Which one would you choose?
To help with your decision, you should figure out what kind of return on investment you can get on $10,000 over the next 3 years.
Let’s assume that you can buy a zero coupon bond paying 5% interest to maturity in three years. If you take $10,000 today and invest it in a three-year zero coupon bond paying 5 percent interest, the future value of the bond will be $11,576.25.
Since that is less than $12,000, you would naturally take out $12,000 over three years.
In fact, you would need $10,366 today to equal $12,000 in three years, assuming a 5% return.
This simple example shows the importance of the time value of money in everyday life.
The Time Value of Money in Financial Decision Making
Here’s how to determine what your $12,000 payment, expected in three years, is worth today.
Now let’s discount the $12,000 earned three years back to today, using the same 5% interest rate. That $12,000 earned over 3 years is worth $10,366 or $366 more than $10,000. Therefore, at a discount rate of 5 percent, it is better to choose $12,000 in three years than $10,000 today.
Now, if you could earn more than a 5% return on $10,000, your decision making could change. If interest rates rose to 7% and you could buy the same 3-year bond with a 7% return, your original $10,000 would be worth $12,250.
So, you would be better off taking $10,000 today and investing it in a zero coupon bond paying 7%.
Here is another way to confirm your decision. Take the $12,000 you were given in three years and bring it back to today using that 7 percent. $12,000 will cost only $9,796. So, with a higher interest rate (discount), you’d better choose $10,000 today.
Use the Time Value of Money to Decide Between a Lump Sum Payment versus an Annuity
The concept of net present value can also help you decide whether a lump sum payment or an annuity with monthly payments is a better option. The answer lies in which choice gives you the greatest present value or present value.
This is a viable option for those who have the option of paying off their retirement accounts or taking a lump sum payment.
What if you had the option of receiving $10,000 a year for 10 years or $100,000 today. Obviously, like the previous example, you can take $100,000 today because you can start investing that money right away. But what if you were given $80,000 today or $10,000 a year for the next 10 years. This choice is not so easy.
Let’s assume that you can invest your money in the stock market and earn an annual return of 7% over the next ten years.
With the present value calculator from Investopedia $10,000 amortized over 10 years and discounted at a 7% return is worth $75,152 today. Compare that $75,152 with the $80,000 received today and you would be better off taking the $80,000 lump sum payment today.
Remember, if expected interest rates change, so will the net worth.
The Value of Time and Money When Buying a Car
The time value of money concept is important in making financial decisions for businesses and individuals. It combines the concepts of net present value and future value.
We just used discounted cash flows to determine how much future cash would be worth today. Businesses use this method to analyze future projects. Investors use this to value securities. and you can use this metric to find the real time value of money.
You can use this strategy to figure out whether to spend today or save for the future.
Understanding what the time value of money means when buying a car will help you make a wise financial decision.
Let’s say you have a choice between buying a $25,000 car or a $35,000 car. For a guess, imagine you’re paying cash. Take the $10,000 difference and imagine you bought a $25,000 car and invested $10,000 in an investment that will earn 6 percent annually for the next ten years. In 10 years you will have a $25,000 car worth $8,000 and a $10,000 investment, worth $18,194.
Add the $25,000 depreciated car, now worth $8,000 and the $18,194 you earned on the $10,000, and after ten years, the value of your car plus the $10,000 invested is worth $26,194.
If you bought a $35,000 car, in ten years you have a ten-year-old car worth about $11,000.
The first condition costs $26,194.
The second scenario costs $11,000 (the depreciated value of a 10-year-old car is $35,000).
This is an example of a trade-off between saving or spending.
You decide that the most expensive car costs $15,194 ($26,194-$11,000) more than the $25,000 model.
Why Is Time Value Of Money Important – Wrap Up?
Understanding the importance of the time value of money in making financial decisions can mean the difference between having what you need for the rest of your life or living the dream now, while setting yourself up for financial problems tomorrow.
The time value of money concept can help you understand what you are giving up every time you make a financial decision.
If you are thinking of buying, ask yourself if the money that is used today, will cost less money tomorrow?
Even buying a latte every day can result in $70,000 less in retirement, if you choose to invest that money instead!
By thinking before you spend, you will avoid financial regrets in the future
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