Barbara Friedberg* explains the concept of Time Value of Money and why satisfying your dreams now can spell trouble down the track.
A bird in the hand is worth two in the bush.
This medieval proverb still holds true today — in certain circumstances.
By understanding the importance of Time Value of Money (TVM), you can find out how to hack the concept for your own benefit.
Here is a TVM example.
What if someone offered you $10,000 today or $10,000 in three years?
Of course you’d take the $10,000 today. In fact $10,000 received today is actually more valuable than $10,000 received in three years.
This is because you don’t know whether inflation will damage the purchasing power of the $10,000.
You can invest that $10,000 to make more money.
Thus, 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 upon what return or interest rate you might earn on that $10,000 in the next three years.
That’s where some smart financial projecting comes into play.
To help with your decision, you must project what type of investment return you can earn on the $10,000 for the next three years.
Let’s assume you can buy a bond paying five per cent interest maturing in three years.
The future value of the bond will be $11,576.25.
Since that’s less than $12,000, you’d naturally take the $12,000 in three years.
In fact, you’d need $10,366 today to equal $12,000 in three years, assuming a five per cent return.
This simple example shows the importance of time value of money in everyday life.
Now let’s discount the value of $12,000 received in three years back to today, using the same five per cent interest.
That $12,000 received in three years is worth $10,366 or $366 more than $10,000.
Thus, at a discount rate of five per cent rate, you are better off choosing the $12,000 in three years over the $10,000 today.
Now, if you could earn more than a five per cent return on the $10,000, your decision making would change.
If interest rates went up to seven per cent and you could buy that same three-year bond with a return of seven per cent, your original $10,000 would be worth $12,250.
So, you’d be better off taking the $10,000 today and investing it in the bond paying seven per cent.
Here’s another way to validate your decision.
Take the $12,000 given to you in three years and discount it back to today using that same seven per cent.
The $12,000 would be worth only $9,796.
Thus, at a higher interest (discount) rate, you are better off choosing the $10,000 today.
The net present value concept can also help you determine whether a lump sum payout or an annuity with monthly payments is a better option.
The answer lies in which choice gives you a larger net present value or value today.
This is a viable exercise for those who have the option of annuitising their retirement accounts or taking a lump sum payout.
What if you have the choice of receiving $10,000 per year for 10 years or $100,000 today?
Well clearly, like the prior example, you would take the $100,000 today because you can start investing that money immediately.
However, what if you were offered $80,000 today or $10,000 per 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 average seven per cent annual return during the next ten years.
With a net present value calculator from Investopedia the $10,000 received for 10 years and discounted back at seven per cent is worth $75,152 today.
Compare that $75,152 with $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 present value.
Understanding the importance of TVM in financial decision making can mean the difference between a life of having what you need for your entire life or living the dream now, while relegating yourself to financial troubles tomorrow.
The TVM concept can help you understand what you’re giving up every time you make a finance decision.
When considering a purchase, ask yourself is the spending today worth a lower net worth tomorrow?
Even buying a latte every day can result in $70,000 less in retirement, if you chose to invest that money instead.
By thinking before you spend, you’ll avoid future financial regret.
* Barbara Friedberg heads Barbara Friedberg Personal Finance. She can be contacted at barbarafriedbergpersonalfinance.com.
This article first appeared at barbarafriedbergpersonalfinance.com.
