It’s easy to fall into the habit of spending a few extra dollars here and there without really thinking about it. With small amounts, we often believe that it’s not really going to make a huge difference in our budget or saving toward our financial plan. Of course, we continue to spend a little more here and a little more there. But, what is often missed is how spending this money today will impact how you will live in the future. Recognizing the potential value of every dollar is a vital step toward achieving financial prosperity.
A fundamental concept for saving money is realizing the importance of the time value of money. This is the idea that a dollar today is worth more than a dollar in the future. So, why is this true? First, you must factor in the impact of inflation. Since inflation steadily erodes the purchasing power of your money, your dollar becomes less valuable and buys fewer goods and services in the future.
Second, you can take the money you have on hand today and get a return (interest, dividends or capital gains) by investing it. While the rate of return will vary over time, in the long run your money should grow. Plus, as you save, you reap the benefit of compounding. Not only will your savings earn interest, but your interest will earn interest. Over time, if you continue to grow your savings, compounding becomes increasingly important. As your balance increases, your account has the potential to earn more on a larger amount of money. This is where you can dramatically improve your net worth.
The relationship between time and money impacts nearly all of the financial decisions you will make. Whether you are saving money for something in the future, such as your child’s college fund or retirement, or considering a loan to pay for a current need like a new vehicle, the time value of money comes into play.
For instance, if we take a look at debt, the time value of money is at work. Whether you have debt from a credit card or student loan or are paying a mortgage, the more time it takes you to repay the money, the more it will cost you due to interest or finance charges incurred for the borrowed money. Time does not work in your favor, and the longer it takes to pay off a loan, the more interest accrues.
On the other hand, when looking at investing money, the more time it has to compound, the better. This is a key point that cannot be underestimated, especially when saving for retirement. The time value of money enables you to enhance the returns that your money can generate over time.
In this example, if you have $5,000 today, and invest it for 5% annual compounded returns for 5 years, your future value will be $6,381. This compound growth is magnified when you take this same amount and invest it for 10 years, increasing its value to $10,395. This is why starting early when saving for retirement can make a big difference. Time works to your advantage.
Recognizing the impact of the time value of money concept and start preparing for a sound financial future.