Question

Why is it important to prepare a financial budget? Explain what is meant by the term "time value of money". For example, why might it be better to receive $8 today, over receiving a promise of $9 seven years from now? How should one consider the time value of money when planning for retirement? Please share examples within your response.

Answer 1

Financial budgeting is a plan created to spend money accordingly. It is a means to balance expenses with income.

It is very important to prepare a financial budget because it ensures that you have enough money always for all the important needs or unexpected expenses and your expenditure does not go beyond your income. If the expenses are made by following the budget plan then one will not fall into a debt or can recover quickly from an existing debt.

Time value of money

Time value of money means that the value of money changes over a period of time. It states that a dollar in hand today has more worth than a dollar which is expected to be received or promised in the future . The money that you have in hand today can be invested and interest can be earned on it and thus has more worth.

As the example in the question states it is better to earn $8 today than receiving the promise of $9 after 7 years. Because the $8 invested today can yield much more profit through investments than the $9 you receive after 7 years.

Time value of money when planning for retirement

Time value of money plays a significant role in retirement planning. The money saved/invested in the pre-retirement years will ensure comfortable retirement life. Retirement plan is important to maintain the same standard of living throughout retirement life.

For example: If a person plans to have $1,000,000 on retirement after 35 years, then this person can reach that amount by investing $1000 on monthly basis for 35 years. A rate of return of 5% can also be earned on this. However, if this person waits for 10 years to start saving for the retirement then the monthly amount will increase as there will be only 24 years more left to reach $1,000,000.

Thus as per the definition of time value of money, the money today has more worth. Therefore investing from today will reduce the monthly burden and ease retirement life.