Time Value of Money Explained
The time value of money is the most fundamental concept in all of finance. Having a grasp of this concept will make anyone a savvier consumer of financial products. From buying a home to leasing a car to saving for retirement, each of these financial decisions cannot be made effectively without understanding the time value of money and its trade-offs.
Before getting into the time value of money, let’s ask the question: What is finance? Finance is the process of moving money to when and where people need it. To illustrate this simple point, let’s consider the process of financing a car purchase.
We need a car now, but we don’t currently have the $20,000 we need to buy it. We have a stable job with adequate income, but simply don’t have enough cash in our bank account to buy a car.
Instead we go to a bank to ask for a loan. The bank evaluates our credit situation: steady job, little to no debt, pays bills on time. The bank decides we are credit worthy and grants us a loan.
We receive the $20,000 that we need and are able to buy our car. We then begin to make monthly payments of principal and interest back to the bank until our $20,000 is paid off. We have engaged in a financial transaction.
So what happened here is that we were able to move money that we would be earning in the future into the present so that we could use it to pay for a car. But what happened on the other end of the transaction? Who was it who gave us the money?
The bank receives its money from depositors — people who have money currently and want to save it for future expenses. In other words, these are people who want to move money from the present into the future.
By taking deposits and issuing car loans (or other types of loans such as mortgages), banks engineer financial transactions that meet the demands of two types of people: those who need money now and those who will need money in the future.
But when we pay back our loan, we don’t simply repay the $20,000 that we borrowed. We have to repay the $20,000 plus interest. Why do we have to pay interest and how do you determine how much interest to pay?
Here’s where the time value of money comes into play. A dollar today is not worth the same amount of money as a dollar tomorrow. That is the time value of money in a nutshell.
Let’s illustrate this with a quick example. Let’s say one friend offer’s to let you borrow $10 so that you can go with him to the movies tonight, but you will have to pay him back tomorrow because he will need it to make a purchase the next day. Another friend offers to lend you $10, but he says you don’t have to pay him back until the next weekend because he has plenty of cash.
Neither friend says that they’re going to charge you any interest. They just need the $10 back. Which friend would you borrow from? One you will need to pay back tomorrow. The other you will need to pay back a week later.
You would obviously choose the friend that will loan you the $10 for a week, because you have plenty of time to earn $10 dollars over the course of the week to pay him back. What this example says is that for every day that we borrow money and don’t have to pay it back, there is value. This value is the time value of money.
How to Price Money
The price that people pay for borrowing money is called interest. How much interest is charged to a particular borrower is determined by three major factors: the supply and demand of money, the credit quality of the borrower and the expense of the financial transaction.
If there are a lot of people who need to borrow money (to make purchases or to start businesses) and fewer people who need to save money, then interest rates are going to be higher. In this case, money is in high demand and it will be more expensive to borrow it.
If there are many people looking to save money and fewer people taking out loans to make purchases or grow businesses, then interest rates will be lower. Demand for money is low. The supply and demand of money is a major factor in determining how much interest to charge a borrower.
If a borrower has a long history of repaying loans, paying bills on time and has a steady income, they are more likely to receive a lower interest rate because they are less risky to lend to. On the other hand, if a borrower has defaulted on a loan in the past or has a shorter credit history, they may have a higher interest rate or may not be able to take out a loan at all because they are riskier to lend to.
Finally, if there is a lot of paperwork involved or a lot of analysis that has to be done in order to make a loan, the interest rate may be higher or a bank may decide to charge an origination fee. An origination fee is a fee charged upfront for originating a loan. Proceeds from an origination fee are used to cover the expenses involved with the origination process.
As you can see, pulling money forward in time comes at a price. If you need money now, then you must be willing to pay interest for it until you can fully repay it. If you are a saver, on the other hand, and need to push money back to a later date in time before you use it, you can expect to earn interest. That is the time value of money.