Finances at Work: The Time Value of Money
Whenever we are looking to understand the true value of money, it is absolutely critical factor time into the equation. This is ultimately because $1 Dollar received today is more valuable than $1 Dollar received tomorrow. There are a few different reasons to explain why this is the case, and these reasons can be most easily understood when looking at hypothetical examples at work.
Example Work Payment Scenario
First, let’s assume you take a work contract that will pay $100,000 Dollars for 1 year. Your company gives you the option of receiving payment up-front, or at the end of the yearly work period.
For most people, this would be a relatively easy decision to receive your money sooner rather than later. But there is more to this decision than just having your money earlier. There is also an actual monetary value that is gained when you avoid the wait to receive your payment. This added value can be gained when you put your money into a checking or savings account that offers an annual interest rate after you deposit your funds.
Effect of Interest Rates
In the United States, interest rates are determined by the Federal Reserve, which is the national central bank. The act of raising or lowering interest rates is generally based on the consumer inflation level that is seen around the country. Higher interest rates mean that you receive more for your money when it is deposited in a bank account.
Generally speaking, the historical average in interest rates comes in at roughly 5% for the United States. This means that you can receive $5 Dollars for every $100 Dollars that is invested in the bank (per year). Of course, this is just an average, as the national interest rate is always changing based on the state of the economy. For this reason, it is always important to have an understanding of the exact interest rate that is being offered by your bank before you deposit your funds. This is the only way to determine the true returns you will receive for the time your money is deposited in the bank.
Accounting for Savings Returns
In our original example, let’s work out the potential for difference in returns for money received immediately versus money received after the year is finished. In the first scenario, you will receive your $100,000 Dollar contract payment immediately. You will then put your money in a 5% savings account and avoid touching those funds for an entire year.
At the end of the year, there will be $105,000 Dollars in your savings account. This is a positive difference of $5,000 Dollars that, ultimately, you are paid for doing nothing. In this hypothetical context, this suggests that the time value for your money is equal to $5,000 Dollars per year. If interest rates were at different levels (for example at 2% or 3%), the time value for your money would be lower.
In the latter scenario, you will receive $100,000 Dollars at the end of the year. This is a difference of $5,000 Dollars, so it should be clear that there is a real world advantage to receiving your funds earlier (as long as you make sure it is invested in a savings account). This is essentially what economists are referring to when they are discussing the concept of the time value of money.
Putting Your Money to Work
The time value of money concept generally refers to the ability to generate interest returns on your money. But it is also important to remember that there is real, practical value in being able to use your funds whenever you need them. This cannot be done if you are waiting to receive your money. Additionally, having your funds in advance can allow you to do things like investing in a business that will generate returns of its own over time.
These types of ‘investments’ include certain levels of risk, however, that are not associated with deposits that are placed in a checking or savings account. So if you were to take your money early and invest in a stock or your own business venture, there would be the possibility of loss that cannot be accrued when your money is deposited in a federally insured bank account.
At the same time, these types of investments create the potential for gains that are more substantial than the relatively low national interest rate. For these reasons, it is important to assess your personal financial needs, your investment goals, and your potential risk for loss that can be undertaken in any of your monetary decisions. This is the surest way of safeguarding your funds and maximizing the potential for returns over time.
If nothing else, it is important to understand that cash itself is not the only thing of value when assessing the purchasing power of your funds. Time is a significant element that is often missed — but it is an element that has its own unique value in contributing to your bottom line.