You will be able to explain the three reasons money now beats the same money later.
An old schoolmate messages you. He needs S$1,000 for a few weeks' rent while he changes jobs, and he offers to pay back S$1,100 in two years, "with interest, to be fair." It sounds generous. You would get S$100 more than you handed over. But is S$1,100 in two years actually worth more to you than S$1,000 today?
Most people answer yes, because 1,100 is bigger than 1,000. That comparison treats a dollar in two years as the same thing as a dollar today. It is not, for three separate reasons, and this module is built on them.
A dollar you have today can be put to work straight away. Leave it in a savings account, a fixed deposit or a government bond and it earns a return while you wait. A dollar that only arrives in two years misses those two years of earning.
Take a rate of 3% a year as an example. S$1,000 kept and invested at 3% grows to S$1,030 after one year and S$1,060.90 after two, using the compounding from lesson 2.1, Simple interest pays on what you put in, compound pays on what you earned. So lending the money costs you that S$60.90 you would otherwise have earned. On this reason alone his offer still wins, because S$1,100 is about S$39 more than S$1,060.90.
Module 4 showed that the same dollar buys less each year. The S$1,100 you get in two years will be spent at the prices of two years from now.
Suppose, as an example, prices rise 2.5% a year. After two years, things that cost S$1,000 today cost about S$1,050.63. Divide S$1,100 by 1.050625 and you find it will buy roughly what S$1,047 buys today. The S$100 extra has shrunk to about S$47 at today's prices. Notice this is a different calculation from reason one. You can earn on money you hold now, and you also lose buying power on money that arrives later. The two often move together, but they are not the same thing.
The third reason has nothing to do with rates. A payment in the future might never arrive.
Your friend might find a job quickly and pay you back early. He might struggle, ask for more time, and pay you in pieces. He might, through no bad intent, never pay at all. Money in your account today carries none of that doubt. A future payment always carries some of it, from almost none for a bond issued by the Singapore Government to quite a lot for a personal loan to a friend between jobs.
The same thinking applies well beyond friends. An employer's bonus paid only if you stay two more years, a promised payout from an insurance plan, an instalment a buyer owes you for a used car: each one is worth a little less than its face value because it is a promise, and promises fail at some rate.
To compare money at different times, you need one number that captures all three reasons. That number is the discount rate: the yearly rate you use to bring a future sum back to what it is worth today.
There is no official discount rate for your life. Choosing one is a judgement. A sensible starting point is the rate you could earn on a safe option you would actually use for this money, which you can look up on the product page or, for Singapore Savings Bonds, on the MAS website. Then add something for the risk that the payment does not come, more for a shaky promise and less for a solid one.
Watch how the choice changes the answer for your schoolmate. At a discount rate of 3%, your S$1,000 would grow to S$1,060.90 in two years, less than his S$1,100, so his offer looks better than keeping the money. Now say you add three points for the chance that he pays late or not at all, and use 6%. At 6% a year, S$1,000 grows to S$1,123.60 in two years, which is more than he is offering. Same friend, same S$1,100, and the answer flips because of a judgement about risk.
Time value of money will not choose for you. You still have to decide what return you gave up and how far you trust the person paying, and the arithmetic then tells you what those two decisions add up to. For longer periods and regular payments the sums get tedious, so lessons 6.2 and 6.3 hand them to spreadsheet functions.
Offers of less now or more later turn up more often than you might think, once you start looking: a discount for paying a year's subscription upfront, a bonus that vests later, a refund paid in instalments. Think of one you have faced recently, and before you work out any numbers, notice which of the three reasons weighs most on your choice.
Write down an offer where you could take less money now or more later, and note which you would pick and why.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).