Time Value of Money Essay Example for Free

Time Value of Money Essay The application of the time value of money theory is very useful in the case of making a decision about obtaining a loan or rejecting it. According to the theory of time value of money, the rule of thumb for making down payment is: if your bank account pays lower rate than the loan, than use your money in the bank account as down payment. This rule is based on the realization of the fact that the value of the money which has been placed on the deposit is going to decline with time, and the percent rate on the deposit which the bank offers is not going to ensure that the value of the person’s money is kept on the same level. At the same time, the person could benefit from making a down payment for a car or any other object because the value of the money would reduce with time and thus he would be paying less for the object which he bought as the result of the loan. Despite the fact that the statements of the time value of money theory are obvious, the author of the article â€Å"Should You Pay Cash for a New Car?† in Los Angeles Times seems to regard all of the issues connected with consumer loans in a different light. Most of the points which he makes in the article are either completely incorrect or need to be altered in order to correspond with the statements which theory of time value of money makes. First of all, the author marks that it is always much better for consumers to obtain loans at the bank instead of investing their own money which they have in deposits. He mentions that consumers did not have computers in order to calculate the benefits of obtaining loans. If they had, â€Å"they might otherwise have seen the advantage in borrowing without taking anyones word for it†. However, as the rule of thumb states, it is profitable to make a down payment for the loan only in that case when the bank account pays a lower rate than the loan. The author does not take this rule into consideration and makes a statement that all of the consumers need to obtain loans, despite the differences between the rates of interest on deposits and loans. The point of view which he is trying to express is that no matter what, obtaining a loan will always be the best possible solution for the consumer. The author mentions the rule which Frank Sperling, vice president at Security Pacific National Bank gives in order to guide consumers in making a choice for or against consumer loans: if a consumer is able to obtain at least half of the interest rate on the investment in comparison with the interest rate on the loan, he is going to make a correct choice by obtaining a loan. This rule is quite similar to the rule of thumb which is being used in the theory of time value of money but it is too concrete of a case. It is impossible to make a conclusion about the interest rate on investment being exactly half of the interest rate on the loan for the deal to be beneficial for the consumer. The benefits of the consumer can be relatively larger if the gap is increased but the consumer can make a down payment for the item which he wants to buy whenever the rate on the loan excesses the yield on investment. The author also states that there can be differences between the rule applications for different types of loans but it is not true because the rule can be applied for any type of loan. It is based on the general objective principles on the theory of time value of money which are universal. Besides, the approach which the author describes does not work in any economic environment. The consumer needs first to realize in what environment the country’s economy is functioning at this point. This can be either the environment of increasing interest rates or of decreasing interest rates. If the interest rates are going to decline in the future, the consumer will need to consider an option of refinancing the loan in the future. If the interest rates are increasing, the consumer might think of obtaining a loan with a lower interest rate now and investing his funds in securities which a higher interest rate in the following periods of time. He also needs to consider the possibilities of obtaining a fixed interest rate for the loan in order to ensure that his payments on the loan are not increasing and invest in floating-rate securities in order to benefit from the interest rate fluctuation in the future. Without the analysis of the economic environment, there is no possibility to make a conclusion about the best possible way of buying a car or any other item. The author also makes an incorrect statement that the major difference between making an investment and obtaining a loan is that the percent rate is calculated on a different basis. According to him, the percent rate on the loan is being compounded only annually and the rate of interest on the investment can be compounded monthly: â€Å"Keppel†¦ calculated that 48 months of interest on a 14.2 percent loan of $8,239.05 would be $2,607.62, while the same principal invested at 8 percent, compounded monthly would earn interest of $3,095.06- a profit of $487.44†. However, this rule is going to be true only in the case when both the loan and the investment have the mentioned characteristics. It is not the general case because interest rates on loans as well as on any other assets can be compounded in any number of ways. It is impossible to say that the investment is going to bring profits to Keppel only due to the different techniques of interest calculations because it is very far from the truth. The question is whether he will be able to obtain the loan and make the investment according to the terms which are favorable for him. The author of the article has expressed complete ignorance in the knowledge of the finance and particularly their theory of time value of money. In order to make a correct decision about the way of purchasing an item, consumers need to make sure they take all of the issues of this theory into consideration.