Question

Being a personal finance counselor, Your very first client is a young couple who want to put their financial business in order and develop a plan for their retirement and future family needs. Both the husband and the wife are 31 years old and in stable employment. They want to retire together at the age of 67. They want you to help them in their financial planning by answering a series of questions, as follows:

1. Why is the fundamental reason that money has “time value”? Does money have time value if (a) inflation rate is zero, and (b) market interest rate is zero?
2. How do you explain to your clients why it is better to start saving now than wait a few years before starting, if they want to achieve a certain amount at retirement? [Hint: convince them from how it may affect their budgets]

Answer 1

a)Time value of money is a financial concepts that basically says that money that is available at the present time worth more  than the same amount of money in future.This is due to the potentail the current money has to earn more money.Even if inflation rate is zero and interest rate is higher than 0,your purchsing power will increase.For example,if you invest $100 today @4% interest,at the end of the year you can buy goods worth $104.Since inflation is zero,you can now acquire $4 more goods than the begining of the year.Thus money has time value even if inflation is zero.

When the market interest rate is zero and there is inflation,the inflation will erode the value of money.Thus even if market interest rate is zero,the money has a time value.

b)Compound interest can be defined as intrerest calculated on the initial priciple and also on the acculated interest of previous year.The real secret to compound interest is less about the amount that is saved and more about of time it is invested.Thus,an investment left untouched for a period of decades can add up to a large sum,even if you are never invest another dime.

For example:

John invests $5000 per year @ 7% begining at age of 18 .At age 25,he stop.He has invested for 10 years and $50,000

Mathew invests the same $5000 per year @7% but begins where John left.He begin investing at the age of 28 and stop at age 58.Mathew has invested for 30years and $150,000.

At the age of 58 John has $602,070 as a maturity value of his investment and Matthew has $540,741.

Mathew has invested 3 times of John,yet john account has a higher value.

This is possible only when you start saving early.