$1 tomorrow is worth less than $1 today. $1 today = $1 tomorrow + time value of money. This time value of money is represented by interest in savings account and earnings in investment accounts.
People in general would prefer to consume $1 today than wait till tomorrow. Now, there are two categories of people – those would would postpone their consumption in return of interest/ earnings. And there are those who would prepone their consumption by paying interest.
Those who prepone their consumption either ‘spend’ that $1 or ‘invest’ that $1 in to their venture hoping for profits. A relevant example of those who spend that $1 are the people who have credit card debt. A relevant example of those who ‘invest’ that borrowed $1 are people who buy stocks on margin.
People who live on credit card debt are in a vicious circle that needs to break at some point in time, otherwise they will get into deeper and deeper problems. Credit card debt accumulates and the interest rates just go on compounding. Remember what Albert Einstein said about compounding.
People who buy stocks on margin are using leverage to enhance their returns. If they are successful, then they earn more than an average Joe who always buys on cash. But if they are unsuccessful they will lose more than the average Joe too. I will write a separate post on margin trading if enough readers are interested.
Now let us come back to the category of people who would postpone their consumption in return of interest/ earnings. These people are called the savers and investors – people who save and invest – who postpone the consumption to tomorrow, people who lend their money for someone else to use and usually manage to get a return on their investment.
Potential earning capacity
We looked at how consuming $1 today is preferred to waiting till tomorrow for consumption.
Now, let us look at it from business/ investment point of view. Money has an inherent earning capacity.
Let us say I have a business opportunity where I will make substantial returns but I need some initial investment. I borrow money from you – now your money together with my skills will make more money. Isn’t it just fair that I share the profits with you?
Word of caution: Please note that I have ignored the chances of default in many of the discussions of this post. We are trying to understand the time value of money conceptually.
In reality, there is always a risk of default (risk of not getting your money back) so one has to evaluate whether the promised returns are commensurate with the risk. Diversification always helps (do not put all your eggs in one basket).
Day to day implications
Whenever you hear the word ‘interest’, you should think of Time Value of Money.
Why does the bank pay you interest? Because there is Time Value of Money.
Why do credit cards have interest? Because there is Time Value of Money.
Why does your mortgage have interest? Because there is Time Value of Money.
Why does your auto loan has interest? Because there is Time Value of Money.
Interest exists because there is Time Value of Money. $100 today is not the same as $100 tomorrow. $100 today is worth more than $100 tomorrow.
Real life example
Someone asked me the following: Ignoring all transaction costs, if I pay $1,000 every month for my mortgage (30 years) and at the end I sell my house for $360k, I should break even, right? Wrong.
Even though arithmetically $1,000 for 360 months equals $360,000. The 360 payments happen during the 30 years while the 360k payment happens at the end of the 30 year period. Hence, the payments that happen every year for 30 are valued more than the single payment at the end.