by Stacy Francis, CFP®, CDFA
I came across an interesting article in the newspaper this morning. Did you know that in many Muslim countries, it is illegal to charge interest when lending someone money? This got me thinking about the concept time value of money – in a way, the very foundation of the US banking system.
The essence of the concept time value of money is that money is worth more now than in the future. All other things being equal, I’d rather get paid $10 today than $10 five years from now. Why?
Well, apart from a pinch of impatience and another one of instant gratification, strictly rationally, $10 today will score me more purchasing power than $10 five years from now. And not only will inflation have made everything I can buy with my money more expensive in five years, but it is also a matter of opportunity cost (what you un-choose when you select a certain path of action). Because if I receive $10 today, and decide not to spend any of it for five years, I can invest it and score myself a yield. Most likely, in five years I will have at least $14 – enough to make up for inflation and then some.
This is why US banks charge you interest on your loans. Because they know about time value of money, and they would rather have the $10 today, too. So you need to compensate them for lending you the money – make it worth it for them. This is also part of the reason we invest. Because if we’re going to put off spending our money, we had better not only make enough off our investments to offset inflation, but we need a little extra to make it worth the wait.
