Why the Time Value of Money Matters, and 10 Ways It Affects You

by Kelly Medeiros on 6 September 2013 0 comments

Learning some basic finance doesn't have to immediately make your eyes glaze over. There's one concept in particular, the time value of money (TVM), which is a fundamental principle in everything from investing to purchasing that becomes more interesting and easier to understand once you drop all the boring finance jargon. So to meet the challenge, here are a few brief descriptions, followed by 10 unexpected (and hopefully more entertaining) examples of the TVM. (See also: Places Teens (and Adults) Can Learn About Money)

First Things First: What Exactly Is the TVM?

The time value of money means a dollar today is worth more than a dollar in the future because it can immediately generate interest. In finance world, if I get $1 today, I can immediately invest it to earn more money (finance world assumes there is always some safe place to earn interest). If I waited to get my $1 until a year from now, I would have missed out on a whole year's worth of earning interest. (See also: How a T-Shirt Equals a Taco)

This also means money in hand today is a sure thing. It eliminates other risks, like default risk, which is when you are promised money in the future, and someone doesn't pay up — such as that friend you lent money to and who still hasn't paid you back.

And let's not forget opportunity costs. These are essentially choices you give up to do something else. When you decide to wait one year to get your $1, the opportunity cost is the year's worth of lost interest that you gave up to wait for your $1.

So, now that you are a financial whiz with these descriptions, here are ten ways to understand the TVM without the usual finance drudgery.

1. Picking Your Lottery Payout

When I win my Powerball $500 million jackpot, I intend to pick the immediate cash payout option instead of the 30 years of future annuity payments. Using the TVM, even though I will initially receive less than $500 million by doing this, I will still get a gigantic sum of cash upfront, which I can invest right away to make even more. I will also have immediate control of my money today, and I will avoid the risk that the lottery commission may not pay up for some reason down the road.

2. The Delicious Cupcakes in My Fridge

We are somewhat obsessed with cupcakes in our house, and rationing hasn't worked. It's clearly better to take your portion right away. Like the TVM, this is true for a couple of reasons. First, a cupcake today is worth more (in taste terms) than a cupcake tomorrow when it becomes stale and the frosting hardens. Also, waiting to get your share tomorrow risks that I will sneak into the fridge later tonight and eat your cupcakes, leaving you with nothing for tomorrow (cupcake default risk).

3. Designer Shoe Purchases

That awesome pair of designer shoes is finally on sale. You charge it to your credit card and celebrate all the way home. However, when you don't pay off your balance until six months later, those shoes really cost you more. That's the TVM at work. The six months of credit card interest charged by your credit card company for the "loan" they advanced you to buy the shoes gets tacked on. Pay off the balance right away, and you won't have to pay for the time value of money.

4. Professional Athlete Pay

Many professional athletes have pay packages that give them a promised amount over a set number of seasons. However, in some sports, if you get injured and miss games, you may forfeit future earnings. Like the TVM, if you can secure an upfront amount today (such as a signing bonus) instead of future payments in years to come, you are better off. Getting your money today eliminates future lost income from injuries (similar to default risk) and allows you to start investing your money for the future — assuming such athletes would do so.

5. Dinner or Shopping

This is an opportunity cost comparison that essentially turns into a TVM concept. You've saved up some extra cash, and since you're an awesome budgeter, you can either spend the money going out to dinner or choosing to buy a new shirt. The opportunity cost of choosing the shirt is the price and enjoyment of the dinner you give up. But, over time, that shirt can be worn again, thereby making this a better option for some. (See also: 12 Cheap First Date Ideas)

However, perhaps dinner out this week is a chance for a date with your dream guy or gal. In this case, the opportunity cost of dinner, which equates to the price of the forgone shirt and future wear, may be small compared to a lifetime of happiness with what could be your future husband or wife (as if it were that easy!).

6. Fine Wines

While I can safely say I am not a regular at fancy wine auctions, there are certain wines that improve with age, which may be worth a whole lot more in the future. According to WineEduction.com, a 1961 Chateau Latour originally cost $3 when it was released and can now sell for $500 at auction. Much like the TVM and that $1 earning interest, such bottles are a similar example, even if I may never get to drink one.

7. Wimpy From Popeye

If you have never seen a classic Popeye cartoon, then break out your Google machine, because the character of Wimpy personifies the risk of a dollar promised tomorrow vs. getting a dollar today. Wimpy was in love with hamburgers, but never could pay for them. He always said, "I'll gladly pay you Tuesday for a hamburger today." In other words, it was highly unlikely Wimpy was really going to pay on Tuesday or any other day for that matter. Thus, whoever gave Wimpy that burger should get his money in hand today because Wimpy was probably defaulting later.

8. Chore Procrastination

Here's an interesting way to equate the TVM into everyday chores. Nobody likes cleaning up, but you may be better off doing it today vs. putting it off until tomorrow. The mess will only grow if left untouched over time, and you will have to put more things away, scrub harder, and do a deeper clean later on. Channel your inner-finance self and realize it's like interest charges piling up. Today's mess grows over time, accumulating more dirt and junk, which becomes an even bigger mess down the road.

9. Exercise

You've heard that exercising and taking care of your body can make for a healthier future. Much like investing in a savings account today, which can yield interest and more savings for the future, investing in your body today through regular exercise can stave off injuries, prevent diseases, and yield future health benefits. If you wait to start getting into shape until you are much older, you forego the accumulated health benefits of exercise, just as you would forego any accumulated interest on your savings. (See also: Fitness For People Who Hate Exercise)

10. Mowing the Lawn

Lawn services can be expensive, but perhaps you can feel less guilty with an opportunity cost comparison. It may take you one hour to mow your lawn, but a lawn service can do it for a fee of $20. If you are a freelancer and need to take an hour off from earning revenue to mow, then if you make more than $20 in an hour, it's worth having the lawn service do the dirty work.

These not-so-mainstream TVM examples hopefully provide a more simplified way to think through this fundamental financial concept. Finance doesn't have to make you run for the hills if you can think of it in practical and more interesting terms.

Can you think of any additional examples of the TVM at play in everyday life?

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