What does the ‘time value of money’ mean?

Let me give you a scenario: You’re out shopping at your favourite mall and I approach you with the following proposition:

“I’ll give you $100 right now or I hold onto the $100 and give you $105 in 7 days time”

Would you take the $100 now or $105 in a weeks’ time?

This isn’t some idea I have just come up with. There have in fact been a number of studies done around the world, using real cash, depicting this exact scenario. And guess what, most people take the $100 on the spot!

What are these studies trying to demonstrate? Well, simply put – they demonstrate that most people have no understanding of the time value of money and how to apply it to their day to day money decisions.

So, what is the time value of money?

The time value of money is the idea that $1 received in the future is worth less than the same dollar received today. This phenomenon is largely due to the eroding impact that Inflation has on the purchasing power of money.

When you have money in hand today, you have the opportunity to earn returns or benefits by investing or using it wisely. If you have to wait for the money in the future, you miss out on those opportunities (also known as ‘opportunity cost’).

Ok, so I can hear some of you asking - “then why were the people in these studies so wrong to take the $100 immediately”?

Well, the answer lies in the fact that they were offered more than $100 next week - $105, in fact. Essentially, they could have taken the option to ‘own’ that $100, plus get a return of $5 on top, completely risk free, simply by waiting a week – This is equivalent to an annualised compound return of 1,164%.

This is why most people who understand the time value of money would almost certainly take the $105 in a weeks’ time.

To be fair, you probably wouldn’t do that calculation on the spot, but what you know for sure is that a 5% return over one week is a lot - certainly much higher than inflation or the return on any other asset you could purchase – and as alluded to above, waiting a week carries no investment risk.

If you understand this basic concept, it will help you make better decisions about things like investments, loans, and savings because you will understand how the value of money changes over time.