Time Value of Money
The time value of money is based on the belief that with all things being equal, individuals prefers to receive payment of a sum of money today, rather than an equal sum in the future. This means today’s value of an amount of money is worth more than the same amount of money at some future date. This is because today’s amount could be deposited in an interest-bearing bank account (or otherwise invested) and at some future time the owner would have the original deposit plus the resulting yield. Consequently, lenders demand interest payments for the loan of their money or financial capital (Time, 2007).
A home mortgage is an excellent example of the value or buying power of today’s currency compared to the currency needed at a future date to have the same value or purchasing power. When an individual purchases a home with a mortgage money is borrowed to pay for that home with a commitment to repay that loan over 15 to 30 years. The value or buying power of the money lent to an individual will not be worth as much 15 to 30 years from now as it is today. Therefore, the lender will want to recoup the amount of money lent to the borrower have the same purchasing power of the money at the end of the loan, and make a profit for lending that money to the borrower. This is why the loan costs the borrower so much over the loan period.
Interest rates normally are higher the longer the loan period. This means the borrower will pay more for the final cost of the mortgage while taking longer to payoff the loan on the home. However, even though the interest rates are higher the longer the loan, the payments are usually lower. This is why most people finance their home for longer loan periods.
According to University of Illinois, Department of Agricultural and Consumer Economics and Department of Finance professors, Sherrich, Ellinger, and Lins there are four reasons why a dollar in the future is worth less than today’s dollar. The four reasons...