Why Is Time an Important Factor in Financial Matters?
If you've heard the expression "a bird in the hand is worth two in the bush," then you've had a glimpse of the logic behind the time value of money. The time value of money is the principle that a dollar in your hand today is worth more than a dollar in your hand tomorrow. And from that fundamental mustard seed of a principle, our credit markets and our whole financial system are born. Credit is simply the lending of a dollar today in return for something more than a dollar tomorrow. And the difference between the two figures, plus the fact that interest compounds, is why time is a critical component in financial decision making.
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Time Value of Money
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The formal definition of the time value of money is the mathematical relationship between money received now and money deferred a given amount of time into the future, at a given rate of interest. The future value of $100, in one year, assuming a 10 percent rate of interest, is $110. The calculation goes both ways: The present value of the promise of $110, to be paid one year in the future and assuming a 10 percent interest rate, is $100.
Rule of 72s
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The Rule of 72s is a shorthand method of calculating the effects of compounding over time. To find out how long it takes for a sum of money accumulating at annual compound interest to double, simply divide 72 by the interest rate. For example, a sum of money compounding at 7.2 percent annually will double approximately every 10 years, while a sum accumulating at 10 percent will double every 7.2 years.
Note that the Rule of 72 works against you as rapidly as for you: Balances on credit cards compound according to the Rule of 72s, just like your savings do--but generally much faster.
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Inflation
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Inflation is the gradual erosion of the purchasing power of money over time. Not all periods are inflationary. In fact, the United States has had several periods of sharp deflation, in which the price of goods decreases. However, the overall inflationary trend has been upward for nearly the entire postwar period. Inflation is a key component in the pricing of credit: The lender must consider the expected rate of inflation when deciding how much interest to charge a borrower. Otherwise, the real, inflation-adjusted return, reflecting an actual decline in purchasing power after the loan has been repaid, would be negative.
Health Considerations
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Some financial decisions, such as the purchase of life insurance, medical insurance, long term care insurance and disability insurance, have a personal time consideration: The tendency of health and life expectancy to decline over time. Insurance that is available and cheap today, while you enjoy good health, may not be available at any price tomorrow--just when you desperately need coverage. If you wait too long to purchase insurance, you may not be able to get it at all.
Tax Law Considerations
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The U.S. tax code also introduces a number of time considerations into financial matters. You must make annual contributions to IRAs before April 15, for example, or the opportunity to contribute that amount to an IRA is gone forever. Or you may have to take a 10 percent penalty on withdrawals from an IRAs or a 401k if you make withdrawals before age 59 1/2--which puts an artificial constraint on your decision making. Other examples include the incentive to accelerate accounts receivables into the current year, to realize income before tax rates go up or to accelerate tax deductible expenses to before Dec. 31 in order to claim a deduction on the current year's tax return.
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