Thursday, 4 February 2016

Why is the time value of money important for your savings?

We all intuitively understand that money in our hands today is worth more than the same amount promised to us the future. For example, we know that if we are given money now, then we can invest it and earn interest so that it will be worth more in the long run. We can see that due to inflation, things tend to cost more over time, making our money worth less. We also know that there is some risk that money promised to us in the future is not as valuable as money that is in our hands right now.

Economists call this the time value of money, but it's important for any person who saves, invests, or borrows. When we invest money, we do so with the belief that it will grow and it will be worth more in the future than it is now.

At the same time, we know that there are always risks when we invest money, and that the value of money tends to decline over time due to inflation. And when we borrow money, we elevate its value to us at that moment over the value of the principal and interest that we agree to pay in the future.

Time value of money and investing

When you sit down to make a retirement plan, you will want to set a goal of having enough money to maintain your standard of living throughout your expected lifetime. Applying the time value of money, we know that the same dollar today will be worth far less in the decades to come. For example, the United States Federal Reserve has been tracking inflation rates for just over 100 years,  and it has averaged 3.22% each year.1

Investors should sit down with a financial planner and account for the future costs of living including food, housing, and energy. Investors and their advisors will also want to take into account the element of risk, so that retirees will have sufficient savings even if their investments do not perform as well as they hoped.

Borrowing decisions

With a home mortgage, the time value of money often works the other way. Homeowners are able to buy down their interest rate by paying a one-time fee as a percentage of their loan, often referred to as "points." Homeowners must weigh the cost of a payment today with the possibility of saving money on interest charges in the future when the true value of the savings will become smaller each month. So if a couple of homeowners are saving $100 a month, they might think of that amount as enough to buy a fancy dinner for two today, yet in 20 years it may barely be enough for fast food.

Let's also apply the time value of money to a credit card statement. Cardholders debating whether they should carry a balance should compare the value of paying their entire balance today with the value of their payments and interest over time. As unsecured debt, credit card interest rates are so high that carrying a balance can be far more costly than avoiding interest by paying the balance in full,  even when inflation and other factors are taken into account.2

By understanding the concept of the time value of money, and applying it to our financial decisions, we make the best choices for our individual needs.

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