The Time Value of Money

We often hear the phrase “the time value of money,” but what does that actually mean? Fundamentally, it means that money now is “worth more” than money later. For example, if I were to put $100 in a savings account at 1% interest, I would have $101 (not including compounding) at the end of a year. How can that be? How does money get more valuable?

It doesn’t. The money itself, when there is no inflation or deflation, retains its original value. In order for there to be any return to money invested, it must be put to work. The only way money can be put to work is by using it to help transform one thing into another thing that is more valuable.

For example, if I take $100 to buy 100 plain wooden blocks and some paint, then invest my time painting the blocks for decorative purposes, I can sell them for, say, $120. The “extra” $20 is the result of my ingenuity and effort. I take cash, some raw materials, and my time and combine them to create value that did not exist before.

If I have an idea for creating such a product, but do not have enough cash on hand to purchase the plain blocks and paint, I cannot create value. A banker or someone else that lends money might recognize my idea as valuable and offer to lend me the money. Say I borrow $100 and agree to pay the lender $105 at the end of a year. I still make $15 on the enterprise. The bank also made money–$5.

This brings us back to our original example–the 1% return on a savings account. For nothing more than the trouble of depositing money in the bank, it pays me 1% It can do so only because it then takes my money and loans it out for 5% It can do that only because someone is willing and able to take that money and create more than 5% value with it.

Now, who makes the most money? We can figure this out by reasoning that a bank will never make money if it lends it out for less than it pays depositors. So the owner of the savings account necessarily makes less money than the bank. What about the business owner? If he/she makes less than the interest rate paid to the bank, that business is a losing proposition. In other words, the business has to make a 5% return just to break even.

This is of course a drastically simplified description of rates of return. The point is that the business owner has the greatest potential of making money. Note that I said potential. Business ownership entails risk, but it is essential for there to be a return on that $100 at all.

Whenever we invest our money, it provides us a return. Behind that return, there is a business, or multiple businesses, actually doing the work of creating value. If the investment is stable and strong, it can be a good strategy for providing for the future. It will never match the potential of a self-owned business, though, because too many other people take their cut first.

Wouldn’t you rather get the biggest cut on at least some of your income? I would, and I’ll bet you would too. Don’t wait, start learning now.

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Filed under business, economy, entrepreneurship, financial crisis, money, new business, retirement

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