“Many people take no care of their money till they come nearly to the end of it. And others do just the same with their time.”
Johann Wolfgang Von Goethe
Use Time Value Of Money To Achieve Your Financial Goals
Understanding financial concepts can help you make better decisions. Time and money relate to each other as in “Time is money.” A dollar in your pocket today is worth more than a dollar received five years from now. The time value of money is the notion that money can grow in value over a given period.
You should save or invest today’s capital so that it is worth more in the future. Present value relates to what the sum is worth today. On the other hand, the future value is what an investment (or a series of investments) made today will be worth later on.
Earning Simple Interest Is Good
Invest your savings today to have more money tomorrow. This earnings capacity’s potential depends on how you invest the money and earn on its interest rate. One way of calculating interest is using the simple interest formula. Here, the principal generates interest income dependent on the interest rate. So if you had $10,000 in your savings account at 8 percent for four years, you would earn $3,200. However, you can do better by compounding the interest.
Compound Interest Is Far Better In Building Your Wealth
A different and more beneficial way is to earn income through compound interest, closely related to time’s money value. Assuming you don’t withdraw any money, compounding allows you to earn interest on interest on your balance. That is, your principal continues to rise as you make interest—the frequency of the compounding matters. More frequent compounding (daily rather than annually) adds incrementally to more money.
Compounding serves as the basis of the time value of money. By adopting good financial habits of saving money, compounding over time is what builds wealth. Instead of earning $3,200 over four years at an 8% interest rate, compounding gives $405 more or $3,605 on your initial $10,000 deposit. Over a more extended time of 40 years, that $10,000 would grow to $217,245. Most of that growth comes from interest earned on interest. Ka-ching!
A Positive Effect On Your Money
Compound interest is one of the most powerful forces of investing. It fuels the urgency to set aside money early for your retirement. This financial term simply means that you add interest to the sum of a loan or deposit or interest on interest. Your balance grows at an increasing rate so long as you don’t withdraw money from your funds.
The power of compounding is the basis of key financial decisions, from your personal savings plan, 529 Savings Plan, retirement, and investment accounts. The earlier you save and invest money in the stock market, the longer the compounding works for you.
To better illustrate the power of compound interest is the classic question, “what would you rather have, a penny that doubles every day for 30 days or $1,000,000?” And the answer is the doubling penny which yields $10,737,418.23. Quite a bit more than the one million dollars. Take a look at our excel spreadsheet here.
It is not reasonable to assume a 100% annual growth rate for any investment annually, let alone daily.
However, suppose you save $2,000 per year in an investment account when you are young at 8% return, and save an additional $500 per month over 35 years. In that case, you could accumulate $1.1 million. Try using a compound interest calculator.
Saving For Retirement Early Beneficial For Growth
The power of compounding interest, linked to the time value of money, will benefit you the most if you save and invest early. Let your earnings accumulate and grow rather than withdraw cash from your accounts. It makes a big difference if you start saving for your retirement ten years later than your friends or if you invest for ten years and then stop contributing to your 401K retirement account. It is difficult to catch up by doubling the amount if you start investing later on.
As a goal, try to contribute to your 401K plan to the maximum level, which is $19,500 in 2021. Some years it may be hard to do, especially when you are experiencing a job loss. Resist withdrawing money from your retirement account as there is usually a 10% penalty tax to do so before you turn 59.5 years. Withdrawing this money will put a dent into your retirement fund that will be painful later on. Instead, your plan is for you to retire comfortably in the future.
Lottery Winners: Lump Sum Or Annual Payments
There is only a tiny probability of winning the lottery. However, it uses the time value of money calculations (present value and future value) to decide whether to win a lump sum or annual payments. Lottery winners, after the rush of adrenaline, have a choice to make regarding time and money. Most lotteries allow the winner to take a lower lump sum or an annuity. The annuity option is a series of annual payments.
If the jackpot is $100 million, the lottery could arrange for 20 annual payments of $5 million while investing a lump sum to fund those payments to the winner. Assuming a present value of a series of equal payments of $5 million at 6%, they would need only $57,349,500 to fund the stream.
What Should The Winner Do?
If the winner takes the lump sum payment immediately (setting taxes aside), they would receive cash of $57,349,500 before taxes. I used a present value of an annuity table, finding a multiple of 11.4699 (at 20 years and 6%), multiplying it by $5 million.
The savvy winner would have the opportunity to invest the money and take advantage of compound interest. They would have to pay federal taxes and possibly state and local taxes as well. Most lottery winners do take the lower lump sum payment upfront. They want to have full access immediately rather than over several years, which is fine if they stave off friends and family who often benefit from this sudden wealth.
Choosing the annuity may be better for tax implications than the lump sum. Receiving a large lump sum can lead to sudden wealth syndrome and the risk of overspending for many people.
Like Warren Buffett, Invest early in the stock market, consistently with a long-term perspective, so you can build lasting wealth.
The Downside Of Compound Interest
When borrowing money, compound interest works against you. Your lenders are reaping the benefits of earning interest on interest on your loans. Consider this when going for a loan such as a mortgage, student loan, personal loan, and credit cards.
Using credit cards can be particularly detrimental when you carry balances rather than paying the entire monthly balance. By merely paying the minimum on your monthly card balance, your debt is ratcheting up quickly with high-cost debt. Most credit cards carry interest rates at the mid-high teens level. Your lenders are channeling the Rolling Stones, “Time is on my side, yes it is..”
Manage Debt Carefully
Let’s say your credit card balance is $5,000 with a 20% interest rate, and you pay only the monthly minimum. The average minimum is usually a small percentage, such as 3% of the balance or a flat amount of $25. We ignore this for illustrative purposes. The issuer will add your interest of $1,000 to your new total of $6,000. At the end of the second year, you will have a debt of $7200, adding interest of $1,200.
The debt mushrooms in a negative way, holding you back from paying your debt off. Spend less than you earn. Make savings your priority, so you outpace the growth in debt and reduce it to more manageable levels.
Related Post: How To Manage Debt For Better Financial Health
Financial Implications For 30 Year versus 15 Year Mortgage
Typically, when buying your home, you put 20% down and borrow 80% of the value of a house or an apartment. You will pay less interest when opting for a shorter-term mortgage.
When comparing the different loan maturities on a $300,000 loan:
- The annual percentage rate (APR) will be higher for the 30-year mortgage than a 15 year one, all else being the same.
- The monthly mortgage payments will be significantly higher for the 15-year mortgage, given the shorter period. If you can afford to pay the higher monthly amount, you are better off with the 15-year mortgage because you pay less in total interest.
- Assuming you have a 720 credit score, the total home price, including total interest paid and down payment, will be lower with a 15-year mortgage loan.
- The 30-year mortgage is much higher because you are paying interest on your loan longer, so the total home price or principal is $375,000 plus $189,622, equalling $564,620.
- If you opt for a 15 year mortgage, your total home price or principal is $375,000 ($300,000 loan + $75,000 down payment of 20%) + $76,012 in total interest equals $451,012 for principal and interest.
Rent As An Alternative To Buying Your Home
On the other hand, renting provides flexibility and freedom. Your rent is usually more affordable than home costs, not having to deal with the home’s repair and maintenance, freeing you to use savings to make investments, and not having to worry about potential declining home values. The downside of renting your home has restrictions to do what you want to make your place more livable. Your landlord could decide to sell the property and require you to move. There is always the risk of having a bad landlord whose actions force you to pick up and leave.
Related Post: A Guide To Buying Or Renting Your Home
Rule Of 72: How Long To Double The Principal
This handy formula always reminded me of a card trick. The Rule of 72 is a simplistic formula used to determine how long an investment will take to double given a fixed rate of return. Simply divide the interest rate that the money will earn into the number 72.
For example, suppose that you owe $1,000 on a loan and the interest rate you are charged is 20% per year, compounded annually. If you didn’t pay anything off at this interest rate, how many years would it take for the amount you owe to double? The formula for this rule is 72 divided by interest rate or 72/20 and equals 3.6 years.
As mentioned earlier, it is always key to use the magic of compounding in your favor and money growth, not debt. For other financial ratios like the Rule of 72, read this related post.
Opportunity Costs in Decision Making
The opportunity cost of any decision is the cost or the value of the following best alternative that must be foregone. We have many choices that may consider time, money, effort, health, and enjoyment in our lives.
When we invest in financial assets and building our net worth, we should consider risk, return, safety, and liquidity. We are making tradeoffs between these variables that we balance off of each other. Am I seeking higher returns in my portfolio and taking on some high yield bonds, or am I opposed to such high levels of risk?
When managing money, you may need to reduce high-cost debt before actively saving and investing. Consider your alternatives and research to find reasonable options. We have written on How To Make Better Money Tradeoffs here.
Time value of money and compound interest are among the most important financial concepts. Understanding these terms can improve your decision-making when managing your finances. Time is money though time is a priceless resource. Use it wisely and more productively.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.