Time Value Of Money Car Loan

There are some basic financial ideas that can seem too complicated to get your head around if seen purely in financial terms. But they are simple enough when seen in terms of daily dealings in money from investing to purchasing. Consider these money matters that most people deal with at some point in their financial lives.

Should you take a loan or pay cash for the car? Should you redeem investments to pay-off the home loan? When you choose to pay for that coveted watch that you cannot afford with your credit card, which you intend paying off over the next couple of years, is that a financially prudent decision?

Are you right in estimating your retirement corpus, taking your current level of expenses as your likely expense in retirement? How much do you set aside for your retirement corpus?

These, and other financial decisions that involve payment or receipt of money at different points in time, require scrutiny to make sure that you have considered the impact of the time value of money (TMV).

Now or later?

Simply put, TVM is the idea that the value of a sum of money, say Rs100, is not the same in the future. This is because money has the ability to be invested to earn returns, and at the same time lose value on account of inflation.

If you had Rs100 today, you could invest it at say 6% per annum, and the value would be Rs106 a year hence. If you had a choice of receiving Rs100 today or one year later, you would choose to receive it today as you can invest it and earn returns. If you were offered Rs106, you would be neutral about receiving the money today or 1 year hence. If you were offered more than Rs106, you would be financially better off taking the money 1 year later.

Another way to look at the time value of money is that the purchasing power of the Rs100 today, and 1 year hence is not the same. Due to inflation, Rs100 can buy more today than what could a year hence when prices are likely to have gone up.

To make the right money decisions then it becomes important to evaluate the value of money involved at the same point in time. Compounding and discounting are the techniques that help factor in the impact of TMV and move the value of money up or down on the timeline. You need the discount rate, which would reflect the effect of inflation and risks in the cash flow and the period involved. Compounding helps get to the future value of a sum of money and discounting is about calculating the present value money in the future.

Subrata Jana/Mint

Present and future values

Many of the personal finance problems are about making choices, and this means evaluating the opportunity cost of making one choice over the other. There are two ways to choose whether to buy a car cash down or on a loan. You could add the present value of all the payments made towards the loan. If the sum of their present values is less than the cost of the car (if bought cash down), then it makes sense to go with the loan. Else, lump sum is better.

The other way is to estimate what the future value of the money would be, if you had invested the funds for the period of the loan. Compare it to the total of the down payment and EMIs you would pay if you took a loan. If the future value of the investment would be higher than the sum total of what you pay towards the car loan, then it makes sense to choose the loan option because your money is better used invested. This is the same evaluation you have to make when deciding whether to pay off a loan by liquidating an investment.

The same principal holds for whether to take a retention bonus as a lump sum, or in instalments over a specified number of years. If you compared only the absolute values of the two options, then taking it in instalments may seem more attractive. However, that would be comparing apples and oranges. The right way to compare would be to find the sum of the present value of the future instalments, and compare it to the lump sum offer. Or, find the future value of the lump sum amount that you can invest today for the period over which the instalments are being offered, and then compare this value with the sum of the instalments.

Compounding and discounting

Just as compounding works to your advantage when it helps your money grow, it works against you when you have to pay back a loan. The longer the period of the loan and higher the interest rate, greater will be the interest component in your repayment.

It is important to understand the interplay between cash flows, interest cost and the period of time to make prudent financial choices. A higher rate of interest and frequency of compounding or discounting results in a higher future value and lower present value: longer the period involved, higher will be the future value and lower the present value. Sometimes there are non-financial aspects to the decision making, such as choosing to pay off a debt for the security of being debt-free, even if it is not the most efficient financial choice. Prioritise your financial and non-financial needs to make the financial decisions that you are comfortable with.

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