Series: General Concepts

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A Bird in the Hand Terms of Use:

Would you rather have $10,000 today? Or would you rather have $10,000 ten years from now? If you answered “today,” you already understand something about the “time value of money."

The time value of money is simply that money in hand today to spend or invest is worth more than money promised tomorrow or some time in the future. Yet this concept is basic to understanding and controlling your finances.

Why is money today worth more than money ten years from now? It has to do with what you can earn on your money (return on investment) or what experts call the future value of money.

Future value is how much the money will be worth at a future date when you count the interest earned on it.

Let's say you have $1000 to invest and you earn 5% interest. In one year, you'll have an extra $50 interest or $1050 total. Therefore, the future value of $1000 is $1050 one year from now.

Of course, different rates of return (the money you make on your investment) will affect the future value of your money.

Related to future value is the concept of the present value of money. Present value is the current value of money that you will receive at some future date.

Using the earlier example, the present value of $1050 you receive a year from now is worth $1000 today.

Money that you spend today can cost you big time in terms of the opportunity to have more money tomorrow (or at some future point). Why? Because the money you use today is no longer available for you to spend or invest. This is what is known as "opportunity cost.”

Another reason that money is worth more today than tomorrow is because inflation eats away at its value. If you have to wait, say, ten years for your money, you will lose some of its value to inflation.

Since the 1920s, inflation has averaged about 3% per year. Take a look at how much things cost in 1970 compared to 2000 in Morris County, New Jersey:

Item

1970

2000

4 Bdrm House: $58,000 $365,000
Ford car: $ 2,140 $ 22,995
Box of Cereal: $ .40 $ 7.00
Movie ticket: $ 1.50 $ 8.00
Tuition @ Yale: $ 2,550 $ 27,130
Gallon of Gas: $ .34 $ 1.57

The money you make on your investments is added to the money that would have been lost to inflation – all adding to the time value of getting your money now.

Series: General Concepts

Page 2 of 2

A Bird in the Hand Terms of Use:

Let's say you won the $1 million lottery. When you turn in your winning ticket, you're asked whether you want the money in a lump sum payment of $1 million now or annual payments of $50,000 for the next 25 years. It Hmmm....let's see. Because of inflation, you know that the dollars you receive today will be worth less in the future. You know that things will cost more in the future than they do now. But how do you figure out what's best?

You can use a financial calculator to figure the present value of the stream of payments. Let's assume inflation will be 4%. Your $1 million if taken over time is only worth $781,000 in today's dollars -- so it is better to take the lump sum of $1 million and have fun investing it.

It is important to understand that the time value of money can work against you, too. Let’s say you ran up the balance owed on your credit cards to $10,000. You’ll have to use future money (which is worth less than today’s money) to pay off the credit card account. You’ll also have to pay interest instead of earning interest. If you just make minimum payments, you’d owe $11,500 after just a year, if the interest on your account were 15%.

The real lesson in all of this is that time (really) is money! It's a good idea to start saving and investing when you're young because you will have time on your side.

For some people, retirement seems like such a long ways out that they'd rather spend money now than save it to enjoy later.

Let's consider why this is not such a good idea: Assuming that you'd like to retire at 62, let's say you have 40 years to work with. If you start putting $3,000 a year into your IRA now, and continue doing so for each of those 40 years (assuming an average annual return of 10 percent), you'd have $1,460,555 by the time you hit retirement.

On the other hand, let's assume you put off saving for retirement for the next 10 years and start when you're 32. Again figuring a $3,000 annual contribution and a 10 percent annual return, you'd have only $542,830 at retirement! By missing those early years, compounding would lose much of its power, and you'd end up with almost a million dollars less.

Think of a timeline running through the past, present and future. $10,000 today has a different value than what it had in the past or what it can have in the future. That’s the time value of money.

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