Monday, June 15, 2009

Why Joe Mauer Needs To Know the Time Value of Money...

A lot of the people that stop by here are ball fans, and I’m one of them. A real treat for Twins fans is watching Joe Mauer – he is crazy good. Not to get too “inside baseball” here but for a catcher to throw out 40% of base stealers is a great accomplishment; for a hitter to get on base 40% of the time is nearly as difficult. Few players can maintain either of these feats for an entire season - Joe Mauer is averaging both for his career. It’s entirely possible that we are watching a player that will be considered the best of all time at his position.

What does that have to do with money? Well, Joe makes a lot of it and is going to make a lot more in another year when he gets a new contract (hopefully with the Twins). It’s a good thing his agent understands The Time Value of Money. And unless you are a sweet-swinging catcher with a rocket arm you better as well.

Before we get into the technical stuff, we’ll lay out a few basics. The time value of money concept applies whether you are saving money or borrowing money. In other words it will impact how much interest you will ultimately earn when you are saving money and how much interest you will pay when you have borrowed money.

In a nutshell, what matters most is how much money you have invested or borrowed and for how long. Don’t get me wrong: the rate of return on your investment does matter, as does the interest rate you are paying on your loan, but these factors don’t matter nearly as much as most people think.

Here are the two most practical examples: mortgages and retirement savings. Most people are very aware of the interest rate they have on their home mortgage but don’t think much at all about how quickly to repay the loan. Let me give you an example. Suppose you borrow $150,000 at an interest rate of 5.5% for 30 years. The total interest you will eventually pay on this loan is $155,970. If you borrow the same amount of money at a higher rate of 6% but repay the loan in 20 years, you will pay $107,335 in interest. Even though the interest rate is substantially higher you will save $48.635 in interest in the second example – almost a third of the total interest paid. Usually, interest rates will be lower when you have a shorter loan term so the benefit could be even more. Many times the difference in the payment amounts between the two examples is minimal, well worth it to save all that money.

The same thing holds true in reverse when it comes to saving money. The earlier you start saving money, the better off you are by far. Here is a very easy way to figure this out, even in your head. At a 7% rate of return, your money doubles every 10 years (at a 10% rate of return, your money doubles every 7 years). So, a hypothetical example is this: a 20 year old manages to save $5000; by the time they are 60 years old, that $5000 will be worth $80,000 without having added anything to it.

If that same person does not save the initial $5000 until age 30, the total value of their investment at age 60 is $40,000 or half as much. Same amount of money saved, just 10 years earlier. The affect is even more pronounced when there are regular monthly additions to the savings amount (principal in money terms), which is typical of retirement type savings accounts.

Bottom line is this: there is no such thing as starting too soon to save and there is no such thing as an amount that won’t grow into something substantial if you if you let the time value of money work for you.

So, when Joe signs his next contract, one of the closely negotiated aspects of the contract, in addition to the actual total amount, will be how much he will be paid at the beginning of the contract, compared to the end. And now you know why.

PS – everyone needs to pass this part of our class as our next post will use this knowledge to take it a step further.