When was the last time you tipped $54 on a $5 coffee? If you’re 30 years old, the answer is probably more recently than you’d suspect.
Any time you buy something, you’re trading away money that could have been invested. If invested, that money would have grown over the next ten, twenty, even thirty or more years. So a dollar today is usually worth quite a bit more down the line.
This is known as the Future Value of Money and it’s an important tool in making financial decisions. If you understand what $1 or $100 today could be worth in the future, you can (supposedly) make better decisions on how to spend (or not spend) your cash.
To understand the Future Value of your money, you only need to know three basic things: how much money you have, what interest rate it could be earning, and how long it could be earning interest (how long you could leave it invested).
The calculation is very simple, and looks like this:
FV = Future Value
PV = Present Value (how much money you have right now)
i = Interest Rate
n = Number of Time Periods (years you could leave the money invested)
So if you have $1 today, and you have the option to invest it at a 5% return for 5 years, the math would look like this:
Future Value = $1.27
This means that if you invest that money, rather than spend it, in five years you could have $1.27. Put another way, if you spend that dollar today, you are choosing not to make a $0.27 five years from now.
Now, the promise of twenty-seven cents five years in the future may not seem like a compelling reason to save that dollar. But where this math starts to get very interesting is when you think about retirement.
Retirement planning changes two very important variables in this equation: the interest rate (i), and the number of compounding cycles (n).
Interest rates on quality long term investments are generally higher than 5%. Because the time-span is also much longer, the money has more time to grow. If you want to get a whole new take on the value of the money you’re spending today, consider this:
Many estimates say that, on average, over the last 40 years, a strong, safe index fund can earn you about 10% per year before inflation. Sometimes it’s higher. Sometimes it’s lower. Sometimes the market falls and you take a short-term hit. But over the long haul, the trend has been about a 10% return.
If you are 30 years old, then you have 42 years (minimum) to leave your money invested. After that point, various laws regarding retirement accounts begin to complicate things. But for the time-being, lets say your money can grow for 42 years, until you’re 72. The math, therefor looks like this:
Future Value = 54.76
This means that every dollar you have today could, if invested, be worth more than $54 when it came time to retire.
Even that by itself doesn’t seem so compelling, so bad is our ability to grasp the consequences of the long-term. But think about it like this: Each time you spend a dollar today, rather than investing it, you’re not just spending a dollar. You’re spending $1, and taking an additional $53.76 away from your future self.
That coffee you bought this morning for $4.33? If you had invested the money, it would have been $237.11 when you hit retirement. If you add a $1 tip, it would have been $291.87.
That drink at the bar last night for $10.65? That would have been $581.55 when you turned 72.
Dinner for $47.19? You just took away $2,584.12 from little old future you.
Am I trying to tell you to avoid spending? To pinch every penny and never tip?
Of course not.
But it is a fascinating way to think about the money you have today. Even if you don’t feel wealthy, looking at your money through the lens of its Future Value shows you that you wield significant buying power, as long as you’re patient enough to let your money grow.
More than that, Future Value acts as a gut-check for compulsive spending, or purchases you’re unsure about.
Let’s say there’s a conference you think you want to attend, but the ticket costs $500.
One way to make the decision easier would be to look at the Future Value of that $500 (which is $27,380 using our math above) and ask whether you feel the conference is worth that much.
If it is, great! You just made your decision easier. Go buy the ticket and get on with your life. If it isn’t, that’s fine. Skip the conference, and put the money towards something more worthwhile.
Even a dinner with friends takes on a whole new shape when you understand the money you’re spending. Even a cheap meal, say $50 in the average US city, has a Future Value of more than $2,500. In a very real way, you’re spending thousands of dollars for that experience. Savor it.
Understanding the Future Value of your money probably won’t end your coffee habit. Nor should it. If you enjoy coffee, then go buy coffee. You can’t live your entire life deferring things to your 72-year-old self.
But what if this knowledge leads you to buy one less coffee per month?
Well, if your coffee’s $5 (and we all know that’s conservative these days), buying one less coffee per month would give you $60 per year to invest. That may not seem like a terribly imposing sum. But through the power of compounding interest, if you were to invest that $60 each year for the next 42 years, it would grow to $32,258.
That is the power of compounding annuities, and that is a story for another time.