Time Value of Money

Have you ever wished that you could see into the future? Unfortunately, we cannot see the future, but we do know some things about it. One of those things is that prices of items which we purchase generally go up in price with time. This is what we call inflation. Rarely do prices of goods go down over the long run. They almost always go up. Inflation is closely tied to the concept of the time value of money. We will now illustrate that concept.

Because inflation is some what of a certainty, a dollar today is worth more than a dollar tomorrow. This is because you can invest that dollar today and it will grow into more than a dollar if invested wisely. To illustrate why that is the case, let’s take a simple example.

Brennan wants to buy a car, so he goes to his friend to get a loan. He asks his friend Hayden, for $10,000 to buy the car. Hayden tells him that he will loan him the $10,000 for 5 years, but at the end of the five years Brennan needs to pay Hayden back $15,000, or 10 percent interest. He says that this is to cover the loss of use of his money for five years. Hayden could have invested that money and earned interest or dividends on the money and it would have grown to an amount greater than $10,000. Another way to look at it is to think, what if Hayden loaned Brennan the money with the idea that he, Hayden, would buy a car in 5 years when Brennan paid him back. The same car will cost more in 5 years so Hayden will need more money to buy the car.

Loans are one of the easiest ways to understand the time value of money. Loans are made with a promise of repayment with interest. There are several ways to calculate interest, but let’s go through some of them using examples.

SIMPLE INTEREST

In our example, Hayden charged Brennan simple interest. Simple interest is calculated by taking the initial loan amount (P) and multiplying it by the interest rate (r) and the amount of time in years (t), like this: P x r x t. In our example it is the following:

$10,000 x 10% x 5 = $15,000

LIFE APPLICATION

Fixed Loans Shrink

Did you know that if you get a fixed loan with a good interest rate, you may actually gain real money if there is inflation; which there almost always is? Let’s say that you get a home loan for 4% fixed mortgage rate for 30 years. If inflation goes to 5% and assuming that your wages keep up, then you are actually deflating the value of your loan. Here are some sample numbers.

Mortgage Loan $500,000 and payment = $2,387.08
Salary $100,000 and monthly earnings of $8,333.33
Ratio of Income to payment = 28.6%

Inflation goes up to 5%, so your company adjusts your wages by 5%. The new comparison is below:

Mortgage Loan $500,000 and payment = $2,387.08
Salary $105,000 and monthly earnings of $8,750.00
Ratio of Income to payment = 27.3%

TIPS and CAUTIONS:

• Beware of variable or adjustable rate loans. They can hurt you if inflation goes up.
• DO NOT keep a lot of cash where it does not earn enough interest to keep up with inflation. If you have $1,000 that you keep in a safe for one year while inflation is 5%, your money will be worth about $995 in today’s dollars at the end of the year.
• Do everything you can to get wage increases at least equal to inflation. If you don’t, you will have less money to live on next year than you do this year.

Related Topics:

• Saving
• Investing
• Inflation