In this post, we dive into how time and money work together, affecting everything from your savings to your expenses. Whether it's figuring out the most cost-effective way to handle annual payments or understanding the best time to contribute to your retirement account, we've got you covered.
Money grows over time. It’s true for both debts and investments and it’s a narrative you might have heard, but may not have understood.
What does that mean, exactly?
At first glance, money seems straightforward: you earn it, you spend it, or you save it. But that’s not the whole picture. There’s a hidden dimension to money that many overlook, especially when starting their financial journey — its time value.
What does this mean, exactly? Imagine you're holding a $20 bill. Right now, it can buy a certain number of things. Fast forward a few years, and its purchasing power might change. This is where the concept of time value comes into play. Money today is not the same as money tomorrow. It can grow through investments or become less powerful through debts.
When you invest, your money works for you, earning more money over time. This could be through interest, dividends, or the appreciation of assets like stocks or real estate. Conversely, when you owe money, the amount you need to pay back often grows over time due to interest charges.
Understanding how this time value of money works is the key to building wealth. Whether you're considering making a purchase, taking out a loan, investing in the stock market, or saving for the future, the time value of money impacts your decisions and their outcomes.
As humans, we expect direct transactions to balance out evenly. We intuitively think that if we borrow something, we should return it in the same quantity. If you borrow a book from a friend, it’s understood you will return that same book, not two, not zero. If you lend someone $20 for lunch, you anticipate getting exactly $20 back. And if you lend an extra fork to a coworker for their lunch, you’d expect to get that same fork back (ideally, after it has been cleaned).
This linear approach to thinking simplifies transactions and interactions in our daily lives. It's a one-for-one exchange that aligns with our sense of fairness and balance, allowing us to navigate social and financial experiences with some level of predictability and stability.
However, when it comes to money, especially in the form of loans or investments, this linear thinking doesn’t quite hold up. The reason? Interest. Interest is the cost of using someone else’s money. When you borrow money, whether from a friend or a financial institution, you're expected to pay back more than you received. This extra amount compensates the lender for the time they couldn't use their money themselves — what they could have earned if they had kept the money or invested it elsewhere.
As such, borrowing money means engaging in a relationship where the amount you repay is determined not just by what you took but by the time it takes to return it. This is a fundamental shift from linear to exponential thinking, where the outcome (the total amount to be repaid) increases not in a straight line but at a rate that can accelerate over time.
Consider borrowing $1,000 with a 7% interest rate. Two years later, you don’t just return $1,000; you return $1,144. But have you ever wondered why?
Interest rates are essentially the cost of borrowing money. They're determined by a mix of factors, including the economy's health and policies set by the Federal Reserve. Higher interest rates make loans more expensive but can encourage saving by offering higher returns on savings accounts. The 7% interest on your loan is a reflection of these rates, aiming to balance the cost of borrowing with the rewards of saving, ensuring lenders are compensated for the risk and the time value of money.
Inflation can be seen in the slow but steady increase in the price of a movie ticket; what cost $10 a few years ago might now be $15. Similarly, the general cost of living goes up over time, which means the purchasing power of your money decreases.
Just like how that $10 movie ticket now cost you $15, over a couple of years, that $1,000 you borrowed won't stretch as far as it once did. Because of inflation, your borrowed money loses some of its punch. This is why interest rates typically run a bit ahead of inflation. It's the lender's way of keeping pace with inflation and making up for not being able to use that money while it's in your pocket.
Deflation, though less common, is the opposite of inflation. It's like finding that suddenly, all the items in your favorite online store are on sale, and your dollar can stretch further than before. If deflation were to occur, the real value of the money you pay back could actually be higher than when you borrowed it. This sounds great for consumers, but it can lead to people delaying purchases in anticipation of lower prices, which can slow economic growth.
The bottom line: if you’re borrowing, ensure you have an asset growing at a similar or faster rate to avoid the pitfall of accumulating expensive debt.
Imagine you've decided to contribute $6,000 to your retirement account this year. The law allows you to make this contribution as soon as you've earned the amount, perhaps by the end of January, or you can wait until as late as April 15 of the following year to make the contribution. This flexibility might seem minor, but it holds a powerful potential for growth.
Here’s why the timing matters: If you have the $6,000 available early in the year and choose to contribute it to your retirement account, you're giving that money more time to grow through investments. If you manage to contribute at the end of January instead of waiting until the following April. That decision means your investment has an additional 14 ½ months to grow. Over just a year or two, this might not look like much, but extend that over a working lifetime, and the difference becomes substantial.
For many, especially those just starting their careers or tight on money, it might be tempting to wait and hold onto cash as long as possible. However, it’s important to remember the magic of compounding interest, where you earn interest not just on your initial investment but also on the interest it accrues over time. This is where the concept of exponential growth comes into play. The earlier you invest, the more you benefit from compounding, turning your $6,000 into a significantly larger sum by the time you retire.
Take a quick look around you. Prices are on the rise. What your parents paid for a gallon of milk is a fraction of today's price, a clear sign of how supply and demand directly impact what your dollar can buy over time.
But don’t worry - you don't need to be a finance expert to see your money grow. Sure, investing is one pathway, but it's not the only one. If you’re ready to make your money work for you, check out your options here
