Money matters: You’re both a lender, borrower
On the Money
From the July 1, 2005 print edition
A recent advertising package from a financial company exhorted the benefits of an “Interest Cancellation Account.” The claim was that by becoming involved with their institution, a consumer could “cancel” interest charges on their mortgage.
Using evocative phrases such as, “dramatically reduce interest” and “innovative principles of money management,” the company seemed to imply it had discovered some miraculous way to erase most of the cost of borrowing.
The company had built an entire campaign around one of the basic principles of finance — the time value of money. Repay debt more quickly and the interest cost is reduced. Invest money as soon as possible and the total return increases. You don’t pay interest on money you don’t owe.
As with all financial transactions, there are always two sides — a lender and a borrower. Both are concerned with the time value of money from opposite ends of the spectrum. More importantly, all of us are simultaneously lenders and borrowers affected by time.
The simplest explanation of the time value of money is that a dollar today is worth more than the promise of a dollar tomorrow or at any time in the future, and it’s worth less than the dollar you had yesterday.
Part of the reason is daily compounding of interest, but there are other factors affecting why a dollar has different values at different times. Most relate to risk.
Interest is compensation for certain risks, including time. If there’s no risk, there’s no interest. Therefore, something must be at risk before interest can be “canceled.”
You have choices regarding the dollar you have today. You can spend it, invest it or hold it. These choices are opportunity cost. That is, what you don’t choose as opposed to what you do choose. Your choices for today’s dollar closely relate to time.
If you spend the dollar, you have purchased something you want or need, and you have it now.
If you invest it, it will earn a return and therefore yield more than $1 at some point.
If you hold it, you still have the choice to make in the future, but you have foregone having today whatever you might have purchased, and you have foregone the opportunity to invest it at today’s rate, term and type.
The promise of a dollar tomorrow carries some risk, often called the collection risk. You might not get it or get it when promised. Depending on the source of your promised dollar, it may have almost no risk or it may have a high one.
Generally, collection risk increases with time, meaning a dollar owed to you tomorrow has less risk of not being repaid than a dollar owed to you next year. More things can happen to prevent the future payment in the intervening time.
Interest rate risk is also involved in the concept of time value. Market rates fluctuate, and the expectation of whether rates will rise or fall affects loan and investment decisions. If you think that rates are going to increase tomorrow, you could wait to invest that dollar then at a higher rate than you would receive today. If you think rates will decrease, you would invest the dollar today.
Today’s dollar, then, has more value than the one you get tomorrow for yet another reason. If rates decrease, not having the dollar today means the opportunity to invest at the higher rate was lost. As with credit risk, the amount of interest rate risk also increases the farther into the future the payment is expected.
Another central factor is inflation. If prices are rising, that dollar in your hand will buy less tomorrow than it will today. This doesn’t mean buy everything now. It does need to be considered when making choices about what to do with the dollar and if it’s invested, what return will be needed to keep ahead of rising prices.
Finally, we come to interest and its role. Interest is an incentive to put dollars to work earning money rather than spending it or holding it. Loans are the reverse from the borrower’s perspective. The borrower is willing to pay for having the money today.
The interest paid is incentive for the lender to make the funds available as loan funds rather than use the money elsewhere. The interest rate is directly related to each of the risks described above, and results from the fact that money has different value at different times.
The forces of the time value of money are constantly operating. All of us are simultaneous borrows and lenders. Remembering to consider both sides of any time-money situation will lead to clear and understandable fiscal choices.
© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.