Let's say you won the $1 million lottery.
When you turn in your winning ticket, you're asked whether you want the money in a lump sum payment of $1 million now or annual payments of $50,000 for the next 25 years.
It Hmmm....let's see. Because of inflation, you know that the dollars you receive today will be worth less in the future. You know that things will cost more in the future than they do now. But how do you figure out what's best?
You can use a financial calculator to figure the present value of the stream of payments. Let's assume inflation will be 4%. Your $1 million if taken over time is only worth
$781,000 in today's dollars -- so it is better to take the lump sum of $1 million and have fun investing it.
It is important to understand that the time value of money can work against you, too. Let’s say you ran up the balance owed on your credit cards to $10,000. You’ll have to use future money (which is worth less than today’s money) to pay off the credit card account. You’ll also have to pay interest instead of earning interest. If you just make minimum payments, you’d owe $11,500 after just a year, if the interest on your account were 15%.
The real lesson in all of this is that time (really) is money!
It's a good idea to start saving and investing when you're young because you will have time on your side.
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For some people, retirement seems like such a long ways out that they'd rather spend money now than save it to enjoy later.
Let's consider why this is not such a good idea: Assuming that you'd like to retire at 62, let's say you have 40 years to work with. If you start putting $3,000 a year into your IRA now, and continue doing so for each of those 40 years (assuming an average annual return of 10 percent), you'd have $1,460,555 by the time you hit retirement.
On the other hand, let's assume you put off saving for retirement for the next 10 years and start when you're 32. Again figuring a $3,000 annual contribution and a 10 percent annual return, you'd have only $542,830 at retirement! By missing those early years, compounding would lose much of its power, and you'd end up with almost a million dollars less.
Think of a timeline running through the past, present and future. $10,000 today has a different value than what it had in the past or what it can have in the future. That’s the time value of money.
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