If you’ve ever taken an introductory finance course then you are most likely familiar with a concept called the time value of money. However, considering that personal finance is not a widely discussed subject in academia, it’s entirely possible that many people have never heard of this topic. The purpose of this post is to explain what the time value of money is as it is one of the most crucial concepts in personal finance.
The time value of money is the reason that people invest their money and is rooted in pretty much every major financial decision in the corporate world. Leveraging this concept is what will allow your net worth to grow exponentially. This is how people achieve financial independence.
In this post, we will go over
● What the time value of money is?
● A few relevant examples?
● How you can use it to your advantage?
Let’s dive into it!
What Does The Time Value Of Money Mean?
The Investopedia definition for the time value of money is “the concept that money available at the present time is worth more than an identical sum in the future due to its earning potential.”
In other words, it means that a dollar today has the potential to turn into multiple dollars at some point in the future. The reason that a dollar today is worth more than a dollar in the future is that money has the potential to earn interest.
For example, when you put one dollar in a savings account it will earn interest throughout the year. At the end of the year, that dollar will be worth slightly more than it was at the beginning of the year. For this reason, it is always better to have money now than to receive an identical sum in the future.
You can see in this example that choosing the second option (taking $1 now and investing it) increased the person’s wealth by 20 cents. We know what you’re thinking. Who cares? It’s 20 cents… However, as the amount of money invested and the rate of interest received both increase this becomes a more powerful tool.
However, before you write this concept off as something that’s only valuable for wealthy corporations, consider the following takeaway from Warren Buffet’s biography. In The Snowball, Warren Buffet recalls how he was notoriously frugal with his money (and he still is). In his mind, every dollar that he spent was really worth $10 in the future (because he could invest it and turn it into more money over time). So for him, when he spent $5 on a T-Shirt, he felt like he was really speeding $50. That type of thinking really makes it easy to spend wisely!
Let’s take a look at a few examples of how this concept can be implemented.
Example 1: You Receive A Raise
Congratulations! Your hard work is paying off and you received a 10% raise which equates to an extra $400 in your pocket each month.
Most Common Scenario
Now, what most commonly happens is that you feel a little rich. You know that you should save some of it but it’s hard now that you can afford nicer things. You go out to dinner a few more times during the month. You buy yourself a new pair of shoes. You upgrade your car since your raise will cover the monthly payment. Inevitably, you end up with very little leftover.
A Better Scenario
After reading this article and understanding that money has its own earning potential, you decide to take a different approach. You still receive the same raise but don’t spend a dime. Instead, you save all $400 every month and at the end of the year, you have $4,800. With this lump sum, you buy stock in Apple.
The next year is a particularly productive year for Apple and the stock price increases by 110%. Now, after doing nothing the entire year but waiting, your investment has more than doubled in value turning your $4,800 into $10,080!!
By making a point to save the extra money from your raise and invest in a place where it will grow, you’ve put your money to work for you and it earned $5,280. You’ve successfully leverage the time value of money.
NOTE: 110% is an incredibly rare return for a single year and used to illustrate a point. This should not be an expected return for a single year.
Example 2: Investing Vs. Saving
As a rule of thumb, we believe that it always makes sense to invest your money instead of saving it in a savings account. This is because savings accounts offer such an insignificant interest rate. The national average interest rate for savings accounts is just .09%.
Let’s take the previous example where you receive an inheritance of $10,000.
If you put that money in a savings account (which typically earns .09% annually in interest) you might think that you’re being responsible. However, if you kept that $10,000 there for 5 years, it would only be worth approximately $10,045 in 5 years.
In fact, it will be worth significantly less than that because of inflation.
Comparatively, if you were to invest that money in a spot where it could get a return of say 5% (which is very achievable) it would grow to $12,762 in the same amount of time. In the chart below, you can see that the difference becomes even more pronounced over a longer period of time. This is how fortunes are made.
All of the above examples dealt with investing in the stock market. However, there are lots of places to invest your money to let it grow for you. The key is to determine how much risk you’re willing to take and what type of return you’d be happy with.
A few examples of other places to invest money are:
- Real Estate
- Gold, Silver, or other precious metals
Determining where to invest your money is when the fun starts. This is when you can leverage the time value of money to make turn your dollars into more dollars. And remember, when in doubt it’s always better to get your money sooner rather than later!
We hope that you found this useful and have a better understanding of what the time value of money is and how to use it to your advantage. Please subscribe below and follow our social channels if you’re interested in reading more or getting alerted of any new articles!