Hey everyone, it’s Finance Fridays again. Today is just going to be a short post about the “Time Value of Money”.
Time Value of Money?
Here’s the definition from Investopedia:
The time value of money (TVM) is the concept that money available at the present time is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also sometimes referred to as present discounted value.
This is kind of simplified as “You’re either earning compound interest or you’re paying it.”
Basically, the classic example is the two choices you get when you win the lottery. Do you take the lump sum payment or do you take the annuity payments?
The lump sum payment is significantly less than the annuity.
For example, let’s take the single largest lottery winner, Mavis L. Wanczyk.
She won $758.7 million (Powerball). However, she opted for the lump sum payment of $480.5 million (before taxes).
The lump sum payment is about 63% of the total if she had opted for an annuity. Also this is before taxes. Just to make the math easy, let’s say Mavis was taxed 40% on her lump sum of $480.5 million. That would leave her with ~ $312 million.
Obviously, there are advantages and disadvantages to opting for the lump sum versus the annuity. However, at first glance you may think that oh, why wouldn’t you take the annuity? You’ll get all the money and the likelihood is the taxes would probably be lower on a year to year basis.
However, the lump sum offers something else. It offers certainty and the time value of money. The taxes will be paid that year and you know how much you actually have. You are able to plan out what you want to do after that point. You are in control.
That said, perhaps you don’t trust yourself and you want to give away some of that control for stability. There is comfort in the knowledge of money coming to you every year for the next 30 years. Perhaps that was Vinh Nguyen’s (no relation) concern when he won $228 million back in 2014. He was the only 1 out of the last 102 Powerball winners up that point to take the annuity.
There are arguments for both. However, the point of this post is to explain that although you’re taking a significant penalty from taking the lump sum, it may not be less money because you move compound interest onto your side.
What would you do?
Well, if you had asked me when I was a kid or young adult, I would have opted for the annuity 100%. I would have been too scared to handle that much money and live in fear of losing it.
However, the me now would probably consider doing a lump sum payment. Don’t get me wrong, I wouldn’t do this without a solid team of a financial advisor, lawyer, and a CPA. That said, I think I would be pretty comfortable with spreading out my risk over various avenues in such a way to provide a reasonable return.
That said, it may also depend on how much money the annuity would pay out every year. If the annuity was paying out more than $1 million a year, that’s a good chunk of no-risk money every year to do nothing.
What does this mean for us non-lottery winners?
It’s just a gentle reminder that the time value of money still applies to us.
Your money should be working for you. Whether that’s your 401k, Backdoor Roth IRA, Taxable Account, Real Estate or whatever your investments are, your money always should be working for you. Once you have your emergency fund in place and you feel comfortable, make sure you are maximizing all your options.
The problem with having too much money in your bank account sitting there is that you spend it. You can’t use it if you don’t have it.
It’s the reason the people like me keep preaching the “pay yourself first” mantra. However, more so than that, keep paying yourself first.
For example, I’ve built a reasonable cushion for myself and now I need to realign myself with our original priority, which was paying down our student loans. My plan is to shave down our emergency fund at the end of this year and throw it at our loans. This should take them down a healthy chunk.
The reason I haven’t done it quite yet is because the lanai (deck) renovation and house repainting is not quite done yet. I want to make sure there won’t be any unforeseen problems requiring more money before I commit to paying down a healthy chunk of our loans.
After that I’m going to start attacking our loans on a quarterly basis. Every quarter I’m going to take any excess off the emergency fund, minus a small cushion for any future travel plans, and throw it at our loans. I am hopeful that our loans will be mostly gone by the time Kylie finishes 5th grade.
As usual, I’ll keep you guys updated.
The Time Value of Money.
Compound interest, earn it or pay it.
You’re a lottery winner! Lump sum or annuity?
It’s an interesting financial exercise to do.
Pay yourself first, and then when you make more money and feel more comfortable, keep paying yourself first.
Agree? Disagree? Questions, Comments and Suggestions are welcome.
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