Underrated financial concept: time value of money

Hourglass on rocks

One of the best videos on Youtube is called the marshmallow test. If you have not seen this yet, do that immediately. They give the kids the option of eating a marshmallow now or waiting a few minutes and receiving a second marshmallow. The kids sit there in sheer agony counting the seconds until she returns with the second marshmallow.

Eventually, they start licking it, smelling it, breaking off little pieces and some even mimic eating it. Then there are the exceptions that just outright eat it and don’t regret it for a moment. This gives an indication of how willing the kids are to delay gratification.

The original studies were fast and loose with drawing conclusions from this test. Stating that is was indicative of success later in life, higher test scores and even went as far as to claim it predicted better body mass index figures. More extensive studies did disproved this. Today I want to tell you what the marshmallow test teaches us about finances. Enter the time value of money.

Time value of money

The concept simply means that R1 million 20 years from now is not the same thing as R1 million today. The value of your money erodes at the rate of inflation. However, if you invested the money today it will be worth multiples of its value today. You can read more about this in my article the future cost of today’s decisions. Any money invested in your twenties is worth 12 times as much in retirement.

In previous articles, I mentioned an investment value somewhere in the future and then would state the value in today’s money. This is the formula I use to calculate the value anywhere in the future:

Future value = Present value Х (1 + Interest rate) ^ Years from now

Applying the time value of money

A good example where the time value of money applies is when taking out a cellphone contract. We tend to think of paying a cellphone contract like buying a car on debt, but these are totally different. This is simply because you do not pay interest on the outstanding amount when you buy a cellphone. If you want to buy a Samsung A20 on contract, the monthly cost on a Made for me XS contract will be R229. Over a period of two years, this adds to R5 496.

To buy the phone on Takealot is R3 199. If you took out a sim only Made for me XS contract, the monthly cost will be R99. This means that the total cost over the two-year period is R5 575. Slightly more expensive than getting the phone on contract. This means that the contract does not charge interest.

When you buy the phone cash, you have a large up-front expense. On contract, you do not have that initial expense. You don’t have to spend that money now and you don’t pay a penalty for spending it later. If you invested the difference between the options, the contract option is R515 cheaper.

This also applies to insurance payments. You can pay the monthly payment any time during the month. So, if you pay it later, you hang on to the money longer and earn more interest on that money. You can read more about this in my article 8 ways to reduce bank charges.

What time value of money means for your retirement

Money that you have now, ensures money for future you. This is why everyone builds tries their best to build a nest egg for themselves. Determining what you need during retirement, is done with the application of the 4% rule (or the rule of 300). This simply means that you can expect to earn R1 per month for the rest of your life for every R300 that you have invested.

The time value of money can ultimately work for you or against you. If you invest the money it will be worth up to 12 times more in retirement. If you keep it under your pillow, the value will erode every year, until it has no value. If you are rolling in debt, time will only increase the burden.

The marshmallow test teaches us that a little restraint today will reward us handsomely in the future. They offered the kids one more marshmallow if they resisted the urge now. Today I want to tell you that if you spend one rand less today, you will be rewarded with R12 in retirement. This adds up to become a massive pile of money.

So always make sure to pay a debt as early as possible, keep money in interest-bearing accounts for as long as possible and save money as early as possible. Future you will thank you and present you will barely notice a change in behaviour.

Be safe out there,

Hendrik

Quote of the week

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Endnote

Thank you for reading to the end. Apparently, the average person spends 8 seconds on a page, so you are special. If you have any suggestions, feel free to drop me a mail on the contact page. If I missed anything or you have questions, don’t hesitate to comment below. I might even notice it and respond. If you enjoyed this article and really want to throw me a bone, please share it.

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