One of the fundamental principles of finance is the concept that $1 today is more valuable than $1 a year from now. The reason for this is two-fold. First, due to the destructive force of inflation, a dollar likely will not go as far in the future. Second, if I have the dollar in my hand today, I can invest it and earn a return in the form of dividends, interest or capital gains.
The best money advice anyone can ever give you is to firmly establish this time value of money concept in your head.
The key to financial prosperity is realizing the potential value of every dollar that comes into your hands. In fact, I think of cash as a seed – you can either eat it (spend it) or invest it (sow it).
To help illustrate this point, let’s assume you find a $20 bill on the side of the road. You are faced with two potential uses: you can stick the money in your tax-free retirement account or take yourself out to dinner. “It’s only twenty bucks!” you say to yourself and opt for the dinner. In reality, you are spending far more. Using one of the time value of money formulas, we can calculate the real economic cost of not investing the cash.
Time Value of Money Formula
FV = pmt (1+i)n
FV = Future Value
Pmt = Payment
I = Rate of return you expect to earn
N = Number of years
To perform the calculation, we have to make a few assumptions. First, let’s assume you are 30 years old (and hence 35 years away from retiring at 65).
That means that the $20 can compound for 35 years. We will substitute 35 for “n” in the equation.
Next, we must establish your expected rate of return. Historically, the stock markethas returned 12%. If you want to invest in bonds, your return will be lower. Assume that you invest in a combination of both and expect to earn a 10% rate of return.
This will be substituted for the “i” variable in our equation.
The “pmt”, or payment, is the value of the single amount you want to invest (in this case $20). Now that we’ve figured out the variables, the formula looks like this: FV = $20 (1+.10)35
Enter 1.10 into your calculator (this is the sum of 1+.10). Raise this to the 35th power. The result is 28.1024. Multiply the 28.1024 by the pmt of $20. The result ($562 and change) is the true cost of spending the $20 today (if you adjusted the $562 for inflation, it would probably work out to about $140 in today’s dollars. That means your real purchasing power would increase approximately 7-fold).
Clearly, this is enough to buy an entrée at a five-star restaurant! Armed with this knowledge, you are free to make an economic decision; namely, would you prefer to eat a $20 meal today or a $140 meal in the future. The answer is entirely personal. Once you understand this concept, however, it becomes painfully obvious that the small luxury items you think nothing of are really costing you millions and millions of dollars in future wealth.
Read the full article at: www.thebalance.com