The Time Value of Money
Incorporate the Basic Financial Concept of the Time Value of Money Into All of Your Financial Decisions
The most basic law in finance! The time value of money states that a dollar today is worth more than a dollar in the future. Okay, it’s not that simple to understand at first glance so let us delve into this advice a little with some financial examples.
If you invest $1,000 in a 5% savings account today, it will be worth $1,050 in one year. Therefore, if you can have $1,000 today or choose to have $1,000 one year from now, it is always better to have the money now. By saving and investing today, you make the time value of money work for you.
Let’s look at the reverse of this, to see how the time value of money can work against you. Suppose instead of receiving $1,000 that you spent $1,000 by purchasing merchandise on your credit card. Remember that a dollar today is worth more than a dollar tomorrow, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today). In addition to having to pay with future money, you will also have to pay interest expense. So, in this case, if you paid off the credit card in one year (assuming 15% interest), you’d have to pay $1,150.
You should think about the time value of money before making any decisions. Another, maybe even more important concept related to the time value of money is the compounding effect of money.
The next rule is to understand the compounding effect of money.