A personal finance blog dedicated discussing such topics as budgeting, asset allocation, 401K, IRA, cash flow, insurance, financial planning, portfolio management, and other areas in personal finance.


Friday, April 22, 2005

Financial Planning Basics - The Time Value of Money

Chances are, if you are out reading personal finance blogs, you probably already understand the concept of the time value of money. For those of you who don't, read on!

If someone were to offer you $100 today or $100 one year from now, which one would you take? If you are like most people, you'd take the money NOW. Why? Because you can take it now and spend it now. In other words, why wait a whole year for something that you can have now? From a financial viewpoint, $100 now is worth more than $100 a year from now. This is the concept of the time value of money: A dollar today is worth more than a dollar in the future.

Why is this so? Two things: inflation and uncertainty. We all know that prices rise over time. At a 3% inflation rate, $100 will only buy you $97 worth of stuff a year from now. Uncertainty is a factor because we don't know what things will be like a year from. Therefore, we need some form of compensation to adjust for uncertainty.

Now, what if someone offered you $100 today or $200 one year from now? Which one would you take? If you waited a year, you would be receiving 100% return on your money. Is it likely that you could take the $100 now and invest it in a manner that would double your money in one year? Not likely! You would do best to wait for a year and take the $200.

So, why am I talking about all this? Because this is one of the most important concepts for you to understand when it comes to personal finance. I'm here to tell you that there really is a rational way to deal with your finances. Life is all about decisions. Knowing how to analyze your situation will help you to make the right decisions.

My next post, I'll give you some more information on the concept of time value of money. Keep coming back and PLEASE tell your friends!