I know what you are thinking. Colby…why are you starting these personal finance lessons with such a boring topic? This is a valid point but my rebuttal is simple: without this lesson you will not understand the rationale behind 99% of all financial decisions so I ask you to bear with me and promise we will get to more interesting things.
- A dollar today is worth more than a dollar tomorrow
- A future amount of money has to be discounted to the present
- A present amount of money can be grown in the future
Why is time equal to money? I will answer this question with another wonderful cliché. Time is money because “a dollar today is worth more than a dollar tomorrow.” Why is this?
Imagine I being the benevolent man I am make you an offer. I will either A. Give you $100 today or B. Give you $100 next week. Which should you choose? If you feel inclined to say “the $100 today” you are absolutely correct.
That answer begs the question: why is that the better deal? It is a better deal because that cash in hand has earning capacity. Put differently with that cash in hand you could lend it out charging a certain percentage to the borrower (an interest rate) and grow the money you previously had to a larger sum. YAY more money!
This concept may seem simple but it serves as a foundation for nearly every financial decision made.
Present Value and Future Value
So let’s introduce some really fancy words that are actually quite simple to understand. If you choose to take the $100 today that money represents your present value. As the word sounds the present value is the worth of some amount of money received in the future today. On the flip side of present value is future value. As you may guess future value represents the value of some amount of money in the future based on the value today.
Now there are equations that accompany the present value and future value, but I think the intuition behind the ideas is more important at this point than the equations themselves.
- Interest Rate: The cost of borrowing an amount of money. It is usually expressed as a percentage of the money borrowed (Ex. A 5% monthly interest rate on $100 would result in a payment of $5 per month)
- Present Value: The current worth of a future sum of money.
- Future Value: The worth of an asset or cash at some point in the future
- Asset: A resource with economic value (ex. Cash, land, house, etc.) Another way to think of an asset is something you own.