The Personal Finance team will be presenting a 90-minute webinar on The Time Value of Money on Tuesday, February 21 at 11 a.m. ET. Learn more about the event.
In the past, I’ve worked as a freelance contractor for various companies, a position that can be interesting and exciting but a bit unpredictable. One thing about freelancing is that sometimes it takes quite a while to be paid, either because a project is long-term (and “payable upon delivery”) or because clients are late with checks!
While my family was not financially dependent on my relatively small freelance contribution, it felt frustrating to know that money was “out there” for me, but not yet delivered. One reason it bothered me? Something called “the time value of money.”
What is the Time Value of Money?
The idea behind the time value of money is that money we have NOW is worth more than money we will get in the future. This is because the money we have now—today–can be put to work today!
Clock by steinchen. CC0 via Pixabay.com.
Let’s say I plan to put my $2,000 freelance check in my savings account, since it’s not money we rely on for daily expenses. Even though on the surface, it might seem like $2,000 now and $2,000 in six months should be equivalent, that’s not the case. If I have it and can put it in the bank now, I can earn interest right now. But if I have to wait six months to receive a check for work I already did, I can’t earn interest during that six months. Or, thinking about it differently, let’s say I want to buy something with that money, such as a new air conditioner. In six months, a new A/C unit might cost more, since prices typically (not always) go up over time. My money is worth more now that it is later.
How TVM Affects Us
So what are some ways that the time value of money, or TVM, affects us in our everyday life? There are a lot, and they may or may not work in our favor, depending. For instance, when we buy something we cannot afford to pay for right now, put it on a credit card, and end up paying a larger total for it in the end, that’s the credit card reminding us of the TVM. (We couldn’t pay them now, so they are charging us to make up for TVM, since they had to wait to be paid.)
One very simple way to think about TVM and make this simple, but powerful principle a part of your mindset is to think about any purchase, especially an optional purchase (say, a luxury item such as a trip or a piece of jewelry) and consider TVM. Imagine that I’m thinking about going on a $2,000 vacation with my freelance check. I can spend that $2,000 now, and enjoy the experience. Or I could invest that money in a financial account that earns me 6% per year. If I can then hold off on spending it, not just today, but for 10 years, I’ll have $6,773! So what’s worth more to me: the vacation now, or the $6,733 later?
Understand TVM to Make Wise Choices
In many cases, saving might be the right choice—but not always. Maybe I’m taking my vacation with teenagers who will have graduated from high school and moved on in 5 years. Maybe I haven’t been on vacation in a long time, and this is a dream trip I’ll always remember. And, of course, in real life, things are more complicated than a simple TVM makes it seem. Inflation eats away at our savings, interest rates fluctuate, opportunities may appear and disappear, and life happens.
The point is, understanding the TVM (and even calculating it!) lets us make a more clear-eyed decision about purchases. This doesn’t mean we won’t make them—it may still be worth it. But we can think more carefully about what we truly prioritize.
TVM calculators are available on the web for those who are curious about calculating this in their own lives. Here’s one. For directions, click on the “How to Use” tab.
We’ll be using calculators, both manual and online versions, in our February 21 webinar on this topic. Learn more here.
