What is "Time Value of Money?"
For our purposes, the time value of money is the growth of money due to compounding interest.
In other words, if you received an amount of money today and invested it into an account that earned you compounding interest, the time value of money would be equal to the balance of the account after a specified number of time periods.
Why is the Time Value of Money Concept Important?
As it relates to personal finance, the most important use of the time value of money concept is for determining the opportunity cost of choosing to spend a given amount of money on one thing instead of any one of the other things that could be purchased at the same price.
And of course, one of the alternative things that could be purchased for the same price, is an investment.
If you spend an amount of money to purchase a good or service for which the value diminishes with time and/or use, the financial opportunity cost of spending that money would be equal to the amount of money you spent, plus the compound interest earnings you will be giving up in the process.
To illustrate, suppose you have a habit of purchasing a $3.50 cup of designer coffee 5 times per week. Using the time value of money calculator you will discover that if you continue this spending habit over the course of a 30-year period, and if you could earn a 6% compounding interest rate on your investments, the financial opportunity cost of the coffee spending habit will add up to a shocking $76,584.94 ($27,300.00 spent plus $49,284.94 in lost interest earnings).
But wait, there is another little-known aspect of the time value of money concept that deserves your undivided attention.
The Money Value of Your Time
In addition to calculating the opportunity costs of spending instead of saving, the time value of money concept can also be used to calculate the opportunity cost of time spent doing something that will not have a positive impact on your financial well-being.
When contemplating how you will spend a given amount of your limited time, you basically have one of six possible choices:
- Engage in a non-financial-related activity that doesn't cost money.
- Expend money.
- Earn money.
- Research ways to save money.
- Research ways to increase the return on your investments.
- Study and train to increase the money value of your time.
The important thing to note from the above list, is if you choose options #1 or #2 you will experience financial opportunity costs equal to the positive effects that options 3 through 6 could have yielded in the near or distant future.
To illustrate, suppose your current hourly wage is $15 and you regularly spend 3-hours per day watching television. If you could earn 6% compound interest on your investments and you chose to work the 3-hours per day instead of watching TV, and you invested those wages for a period of 30 years, plugging these numbers into the time value of money calculator will reveal that the financial opportunity cost of watching TV will add up to a staggering $1,382,335.07 ($492,750.00 of lost wages plus $889,585.07 of lost interest earnings).
And that's only one of hundreds of time value of money examples I could give that illustrate how your actions and inactions today have a compounding effect (positive or negative) on your financial future.
Unfortunately, every time I venture into a store I'm quickly reminded as to just how many consumers are completely oblivious to what they are really giving up in exchange for all those shopping carts towering with non-essential consumables.
For the sake of your family's financial future, I hope you will join the elite group of consumers who make it a habit to calculate and carefully consider the time value of money in all of their time and money related decisions (ALL decisions have time and money related consequences).