Provided By Jeffrey Larson, Regional Director at Larson Financial Group
Imagine a friend owes you $1,000. If you had the choice, would you rather have this money repaid to you right away in one payment or spread out over a year in four installment payments? The vast majority would prefer the former, and rightly so. This goes far beyond the instant gratification of receiving the money sooner rather than later. The simple truth is that money has greater earning capacity now than in the future, and $1,000 today is more valuable than $1,000 a year from now.
This concept is called time value of money, and is a fundamental principle in business and finance. This philosophy that states the earlier you receive money, the more earning potential it has. You can invest a dollar today with the potential to earn a return on that investment in the form of interest or dividend payments. Compound interest is always assumed in time value of money applications.
Compound interest measures the impact of the time value of money over multiple periods into the future, where the interest is added to the original amount. Therefore, you are not only earning interest on the principal amount invested, but you’re also earning interest on the interest. For example, if you invest $1,000 at 10% for 20 years, its value after 20 years will be $6,727, assuming you don’t withdraw the interest amount earned each year with the investment.
The opposite of compounding is discounting, meaning that it is essentially the inverse of growth. This determines the present value of money to be received in the future (as a lump sum and/or as periodic payments). The present value is determined by applying a discount rate to the sums of money to be received in the future. This methodology can be used to analyze any investment that has an annual cash payment and a terminal or salvage value at the end of the time period.
CEOs, investors and entrepreneurs use this theory frequently when dealing with loans, valuing companies and budgeting capital. However, there are several ways this concept can be applicable to the life of a physician as well, such as comparing investment alternatives and making decisions regarding your physician mortgage loans and medical school loan repayment.
Let’s use purchasing a home as an example. One of the first decisions in this process is determining how large of a down payment to make and how much will be financed. Since there are several factors at play, there’s no one-size-fits-all answer.
In some cases, you can obtain a more favorable interest rate by putting more money down. However, you need to assess the economic component of this decision. Is the potential savings from a favorable interest rate more than the potential earnings if invested? Would you have adequate money for emergency expenses? Once this cash goes into a down payment, that money would have to be “loaned against” for future use.
This concept can also be useful to those who already have physician mortgage loans. You might find yourself in a position where you can liquidate your investments and pay off your home. But, is that the smart thing to do? Economic and asset protection factors may suggest that maintaining a mortgage makes the most sense, but the emotional toll of debt needs to also be assessed. Debt impacts us on a psychological level, and if you’ll sleep better at night with a house that is paid off in full, then that may be the approach that makes the most sense for your individual situation.
Time value of money could also influence your strategy for medical school loan repayment. It may be tempting to pay off these loans in full, however, if the interest rates on your student loans are favorable it may not be a priority. You could save this money for investment opportunities or pay off other debts with higher interest rates.
Time is Money
Since money has time value, the present value of a promised future amount is worth less the longer you have to wait to receive it. Real estate investors frequently calculate present value to estimate their profits on a deal. Future value is the amount that is obtained by forecasting the value of a present payment or a series of payments at the given rate of interest. We naturally expect the future value to be greater than the present value due to the time value of money. The difference between the two depends on the number of compounding periods involved and the interest rate. Suppose you invest $1,000 in a savings account that pays 10% interest per year. The future value of that investment would be $1,100 one year after the money was deposited.
The value of the money you have now is not the same as it will be in the future. There are several reasons why this is commonly accepted besides the accrual of interest or dividends. Inflation, for one, exacerbates this trend by decreasing the purchasing value of an amount of money. Receiving the money immediately also reduces the risk of default. As you can see, “time is money” is true in the literal sense.
This article if for informational purposes only and should not be construed as tax advice. Advisory Services offered through Larson Financial Group, LLC, a Registered Investment Advisor. Securities offered through Larson Financial Securities, LLC, Member FINRA/SIPC.
Larson Financial Group, Larson Financial Securities, and their representatives do not provide legal or tax advice. Please consult the appropriate professional regarding your legal or tax planning needs.