When money professionals mention “the time value of money,” most people’s eyes glaze over. Professionals only make it worse by following up with, “A dollar today is worth more than a dollar a year from now.” (For example, in this article from The Motely Fool.) What? Who cares about a measly dollar? Let me explain the time value of money by rephrasing the question.
When Would You Like Your $10,000?
When I explain the time value of money to someone, I pose this simple question. I can give you $10,000. Do you want it today, or a year from today?
Today, of course, says everyone ever. It’s instinctively the right answer.
Then I ask the person, why?
Everyone answers it’s because they can do stuff with the money, possibly even invest it and earn more in the coming year.
So yes, that’s the time value of money. A horrible label for something everyone understands instinctively.
The Time Value of Money From the Future
There’s also the flip side of the coin: Money in the future is worth less today. This concept is a little more abstract, but you see it in some situations. One instance that many people recognize is lottery winnings.
Let’s say you’re lucky enough to win a $100 million lottery. Awesome! The folks at the lottery office give you two options. You can have $100 million paid to you in $5 million annual installments over 20 years, or you can have about $55 million today. Why is that? Because the advertised prize is the series of futre payments. If you want your money today, it’s worth less than the future money. This is for the same reason: if you get the money today, you can do more with it. Over the same 20 years, you can make it worth $100 million or more.
The same holds true for the lottery officials. If they can hold on to their money now and pay you later, their money is worth more to them today. So, they offer you less.
(You also see this side of the time value of money when investing in some bonds and annuities. I’ll save those topics for another day.)
Why the Time Value of Money Matters
There are ways to precisely calculate the future value of today’s money, the present value of money in the future, and whether you really should take the money now or later. Microsoft Excel and Google Sheets have formulas for calculating present and future values. Some websites offer calculators for the time value of money. If you want more specifics about determining the time value of money, post your comments below.
For now, what you need to know is that the combination of money and time is powerful. It’s why you want to start saving early for your life’s biggest purchase–retirement. It’s what powers the R Minus 10 retirement calculator. It’s the force that will accumulate the majority of your retirement savings for you.
(Image courtesy of WikeMedia)