When is a dollar not worth a dollar? When it is given at a future time. Understanding the time value of money is an important part of your financial strategy. It will also help you identify when you are being ripped off.
Think about the interest you earn with your savings and understand that you would rather have a dollar now than in the future. Say, for instance, the interest rate at the bank is 5%. If you take the dollar now, it will be $1.05 a year from now. If you take it next year, it will only be $1. The people who design lotteries know this. Generally, lottery winnings are paid out gradually over time. If the winner wants the money all at once, he receives a reduced amount. This is because the winnings paid in the future are worth less than the winnings paid now.
Apply the concept of the time value of money to save money for yourself. If you pay bills online, select the due date as the payment date. Also, don't have your employer withhold more taxes than necessary. If you owe taxes at the end of the year, pay them on April 15th. While you keep your money longer, you will be earning interest on it.
If you are owed money, try to get it faster. If you own a business, shorten the payment terms. The sooner to receive the money, the sooner you can start earning interest on it.
Don't be fooled by politicians. If you are an employee, you pay more than 6% of your earnings to social security. Calculate how your money would grow over the years if you invested it instead. This is what you are really paying.
Don't be fooled by your employer. If you have a defined benefit plan, remember that you are contributing money that you could be investing. If you don't understand the time value of money, they may fool you into thinking that you are getting a better deal than you really are.
Tips & Warnings
- Apply this concept to friends. If you owe a friend a large sum of money, do something for them in addition to paying them back.
- Be sure to pay bills and taxes on time. Penalties and interest charges will far outweigh the interest you will earn by keeping the money longer.
- Principles of Engineering Economics
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