Keeping Time On Your Side
I'm sure that you're acquainted with Benjamin Franklin's wise counsel that "a penny saved is a penny earned." In fact, a penny saved may be more or less than a penny earned, depending on when it is earned and how it is saved. The reason is rooted in a concept called the time value of money.
Which would you rather have, $10,000 today or $10,000 a year from today? I'm sure that you would choose to take the money now - any investor would - because you should understand that the value of $10,000 a year from today will be eroded by a year's worth of inflation and a year's worth of lost interest on the money. To make it easier to understand, if inflation is running at 5% and you could earn 7% in interest over a year's time, the thrill of being handed $10,000 today is worth about 12%, or $1,200, more than the thrill of being handed $10,000 a year from today.
The time value of money works against you if you're the one waiting to collect the money, but it works in your favor if you're the one who has to pay. Success with your money often lies in being able to identify the winning side of the time value equation.
It is the time value of money that permits state governments and other sponsors of sweepstakes and lotteries to promise fantastic payouts that actually exceed the amount of money they take in by selling tickets. However, you don't have to win a lottery to contemplate whether you're headed for the winning or losing side of the time value equation. As an investor, you must always keep in mind one basic principle - that a dollar you pay or receive today is worth more than a dollar you pay or receive tomorrow - and if you never forget this principle then you will wind up on the winning side more often than not!
Here's an example to prove the point: Ignorance of the time value of money can cause you to think you're doing something smart when you're not. Now you have probably heard high praise for the 15-year mortgage. Because you pay it off sooner than a 30-year loan, you pay less interest and thus save tens of thousands of dollars. But, the homeowner with the 15-year mortgage parts with the money sooner than the 30-year buyer, and the time value of money suggests some caution may be in order before exaggerating any claims of savings. You need the answers to two very important questions: 1) What else might you do with the extra money you'd be spending on the higher monthly payments required by the 15-year mortgage? and 2) How much could it earn if you invested it in something other than mortgage payments?
Suppose it costs you an extra $200 per month to pay off the loan in 15 years instead of 30. That is then $200 a month not available for investing in something else that might pay a greater rate of interest than the rate of your mortgage loan. If you could invest that $200 in something that pays 2% more than your mortgage, then that $200 per month earning 2% and compounded for 15 years will grow to almost $42,000. That represents your opportunity cost to pay off your mortgage early, and you must subtract it from any savings you think you've made by paying off your mortgage early.
Opportunity cost is the cost of doing one thing and not another. To make sure you don't overlook it, ask yourself before you make any investment or spending choice: What else could I do with the money?
* * * * *
Which would you rather have, $10,000 today or $10,000 a year from today? I'm sure that you would choose to take the money now - any investor would - because you should understand that the value of $10,000 a year from today will be eroded by a year's worth of inflation and a year's worth of lost interest on the money. To make it easier to understand, if inflation is running at 5% and you could earn 7% in interest over a year's time, the thrill of being handed $10,000 today is worth about 12%, or $1,200, more than the thrill of being handed $10,000 a year from today.
The time value of money works against you if you're the one waiting to collect the money, but it works in your favor if you're the one who has to pay. Success with your money often lies in being able to identify the winning side of the time value equation.
It is the time value of money that permits state governments and other sponsors of sweepstakes and lotteries to promise fantastic payouts that actually exceed the amount of money they take in by selling tickets. However, you don't have to win a lottery to contemplate whether you're headed for the winning or losing side of the time value equation. As an investor, you must always keep in mind one basic principle - that a dollar you pay or receive today is worth more than a dollar you pay or receive tomorrow - and if you never forget this principle then you will wind up on the winning side more often than not!
Here's an example to prove the point: Ignorance of the time value of money can cause you to think you're doing something smart when you're not. Now you have probably heard high praise for the 15-year mortgage. Because you pay it off sooner than a 30-year loan, you pay less interest and thus save tens of thousands of dollars. But, the homeowner with the 15-year mortgage parts with the money sooner than the 30-year buyer, and the time value of money suggests some caution may be in order before exaggerating any claims of savings. You need the answers to two very important questions: 1) What else might you do with the extra money you'd be spending on the higher monthly payments required by the 15-year mortgage? and 2) How much could it earn if you invested it in something other than mortgage payments?
Suppose it costs you an extra $200 per month to pay off the loan in 15 years instead of 30. That is then $200 a month not available for investing in something else that might pay a greater rate of interest than the rate of your mortgage loan. If you could invest that $200 in something that pays 2% more than your mortgage, then that $200 per month earning 2% and compounded for 15 years will grow to almost $42,000. That represents your opportunity cost to pay off your mortgage early, and you must subtract it from any savings you think you've made by paying off your mortgage early.
Opportunity cost is the cost of doing one thing and not another. To make sure you don't overlook it, ask yourself before you make any investment or spending choice: What else could I do with the money?
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posted by Bob Moser at
1:43 PM
7 Comments:
And you don't believe in credit cards?
Buy with today dollars and pay with future dollars.
The next step is Reaganomics. Spend today and play it off much much much later.
The trick of becoming rich is to buy assets with today's dollars on credit on a 0% introductory interest rate. When the introductory rate expires, flip the debt to a new credit card at another 0% introductory interest rate.
Repeat again and again and the assets are yours after 22 years of paying the minimum payment with future dollars.
By
erik, at 7:55 PM
Well that approach of "flipping" between credit cards sounds very much like "voodoo economics!"
What happens when the credit card you had been using expires and there is no new "0% introductory interest rate" offer to replace it?
By
Bob Moser, at 4:56 PM
You always buys liquid secure assets with the debt.
I am financing ibond purchases this way for over 2 years now.
Now that that option is gone, I just have money in the bank earning 3% while paying 0% interest.
You need cashflow however to pay then minumum payments however, because the interest is not enough to the minumum payments.
If reaganomics comes to an end, you just cash in you assets and walk away with the interest.
By
erik, at 11:59 PM
This comment has been removed by a blog administrator.
By
Bob Moser, at 6:41 PM
This comment has been removed by a blog administrator.
By
Bob Moser, at 6:41 PM
Well this approach that you described is definitely not investing. It is speculation pure and simple!
The people who market these "0% deals" aren't stupid. They use that ploy as a "hook" to get the unsuspecting credit card holder to take them up on their "0% offer" because they know that in in 95 out of a 100 cases, the person will add other charges to that same credit card on which they took the "0% bait" and that's where the credit card company makes out like a bandit because they will charge the full interest rate on all the new added charges!
So anyone who uses a "0% offer" needs to be very careful to not add any other charges to that credit card until he/she has paid back the "0% loan" in full!
By
Bob Moser, at 6:41 PM
Yes, and index fund beats 95% of the professional investors.
Deffered payment on credit on prefferred terms is a standard business practice. There is nothing wrong, immoral, or unamerican about. Apply these same practices on your personal finances is a good idea.
Insurance companies due this daily and build a float of free money that is not theirs. Buffer made most of his money off of the levages that the float provied him.
This blog is also for above average investors which I can assume have the money to pay of their credit cards.
If you are a below average investor and can not payoff your credit cards. Get a 0% intro balance transfer anyway and saving some interest for 12 months and reduce your debt.
By
erik, at 6:49 PM
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