One of the biggest things that I try to get my students to understand is the value of the financial concepts I teach — beyond the grades that they earn in my course. If you look at the people who have been victimized through financial swindles or simply made poor financial choices, much of their misfortune can be traced back to limited financial knowledge. If you’ve never taken a business course (let alone a finance course) before, it may be a bit daunting to know where to start. I wouldn’t necessarily recommend going back to school just to learn how to manage your money, but I think some self study might be in order. I’m working on a ‘top 10′ list of my favorite personal finance books, but today I just wanted to share an anecdote.
Lately I have begun teaching more and more online courses. To do so, I put audio recordings with accompanying PowerPoint slides on a secure website that my students can access. The website is free up to a point. Yesterday, I reached the point where the site was no longer free and I would have to pay a fee in order for my students to continue to have access to my lectures. OK. No big deal. I was given two choices: 1) pay $9.95 per month or 2) pay $99 per year. At first blush, you might argue that the annual deal was better because you save $20.40 (17%) over the monthly deal. It is a better deal, but simple math only tells half the story. You really need to understand the time value of money to truly appreciate the differences.
Let’s look at it from another perspective. Assume that one person offers to pay you $9.95 every month for one year and another offers to pay $99 today. Which is better? Several issues impact the value of this deal. First, one dollar today is worth more than one dollar tomorrow or next week, so the person offering to pay you over time will have to give you an incentive to entice you to take the deal. In financial markets, that incentive is called interest. Interest is what effectively equates that dollar you receive tomorrow to that dollar you receive today. The longer you have to wait to receive your dollar, the more interest you need. The reason for this is that the dollar you receive in the future isn’t worth as much as it would have been had you received it today — meaning, you will have less buying power due to inflation. Further, the fact that you must forego consumption today is an inconvenience that deserves compensation as well. Finally, there is default risk. What if that clown just doesn’t pay you as promised? All of these risk factors go into the interest rate calculation.
So let’s go back to those two offers. In order to compare them, we need to evaluate them both at the same point in time. The $9.95 monthly payments represent an annuity because you will receive the same amount at regular intervals. To figure out what that stream of payments is worth to you today, you would need to invoke what is called ‘the time value of money’ and figure out their present value. It turns out that if you use an interest rate of 10%, those payments are worth $113.18 today (a little less than their combined total of $119.40). That effectively means that if you took that $9.95 that you received each month and invested it at 10% (per annum), you would be better off with the monthly payments because at 10% interest, they are worth $14.18 ($113.18 – $99) more than the lump sum payment today.
Some folks might think that investing at 10% is fairly unrealistic given today’s market, so let’s look at this a different way. What if you were told that if you invested $99 today, you could receive $9.95 per month in return for 12 months? What rate of return would that represent? It turns out that this is a 36% return (per annum)! So, if you thought 10% interest was a lot to expect, how does it strike you that the interest rate that it would take to make $99 today equal to $9.95 per month for 12 months is 36%?!
Finally, let’s relate this back to my dilemma of paying $9.95 per month or $99 per year. From an investing perspective we have discovered that receiving $9.95 per month yields a 36% return on a $99 investment. Therefore, from a spending perspective, paying $99 per year yields a 36% discount as compared to paying $9.95 per month. I guess you know which one I picked!