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The cost of money: Why it changes and why that matters to you

At a glance:

  • Measuring the cost of money

  • Important terms used in calculating interest

  • Why the cost of money varies

  • The cost of money and the economy

  • Summary of the cost of money

"A dollar today is worth more than a dollar tomorrow" because of the time value or cost of money.

The cost of money is due to inflation and other factors. It is often measured or represented by the interest one must pay to get money.

As an educated investor, you need to be very sensitive to the cost of money, as it will guide you in your investment decisions.

You may have noticed that the price of gasoline has gone up. What if you took a dollar and bought some gasoline today: How much could you buy—half a gallon, a quarter gallon? If gasoline were to cost $2.00 a gallon, you would be able to buy only half a gallon of gasoline.

But what if you took that dollar and, instead of buying gasoline, buried it in a coffee can under a tree for a year and then dug it up—how much gasoline could you buy then?

We really do not know the answer to that question, but let's look at the scenario going backward.

According to the U.S. Bureau of Labor Statistics, the price of that same gallon of gasoline cost about $0.65 this same time just over 40 years ago, which means that a dollar back then would have purchased over 1½ gallons of gasoline.

In other words, the same dollar purchased about three times as much gasoline 40 years ago as it does today.

What happened to the dollar?

Since the gasoline of which we speak is not the new and improved variety that gets you further per gallon, the only conclusion we can draw is that the dollar somehow became worth less today than it was then.

Of course, you recognize this phenomenon as inflation.

Inflation is the tendency for prices of goods and services to increase over time. Inflation affects all our goods and services, not just gasoline.

Economists have many theories as to why this phenomenon occurs, but suffice it to say that regardless of the reason, it does seem that a dollar today is worth more than a dollar tomorrow.

U.S. one-hundred dollar bills are seen in this photo illustration at a bank in Seoul August 2, 2013. Picture taken August 2, 2013. South Korea's foreign reserves jumped to a record high in July, the central bank said on August 5, 2013, appearing to support traders' suspicions of dollar-buying intervention by currency authorities last month. The reserves stood at $329.71 billion at the end of July, up $3.27 billion from June, the Bank of Korea said in a statement, attributing the rise to management gains and the appreciation of the euro in July, which the Bank of Korea said was up 1.8 percent against the dollar last month. REUTERS/Kim Hong-Ji (SOUTH KOREA - Tags: BUSINESS)
U.S. one-hundred dollar bills are seen in this photo illustration from 2013. (Photo: REUTERS/Kim Hong-Ji)

What interest is for

This brings us to the point that there is a cost of money—sometimes referred to as the time value of money.

Instead of burying your dollar in a coffee can, you lend it to a friend for a year. When you get it back, you will not be able to buy the same amount of goods or services you would have been able to buy had you spent it instead, yet your friend did enjoy the full value of your dollar.

You should be compensated for the loss of value, right? Interest is the compensation for the loss of value of money over time—it is the cost of money.

Interest may be tied to inflation, but it may also have a risk component, or "risk premium." A risk premium is an extra charge added to inflation to make up for the potential loss of value due to default, and is part of interest.

Measuring the cost of money

Interest is the charge added to a loan that makes up the cost of money. Interest is usually expressed as a percentage of the loan principal. The principal is the original amount of the loan.

The interest rate tells you what percentage of the unpaid loan will be charged each period. The period is usually a year but may be any agreed-upon time.

How it works

Here is how it works.

Let's say you loan your friend $100 at 5% annual interest. At the end of a year—the period—you should receive $105, or $100 of principal and $5 interest. Simple, isn't it?

Let's say your friend doesn't repay the $100 principal, but pays you only the $5 interest; then the next year your friend will still owe you the $100 plus another $5 in interest. The preceding is an example of simple interest. Simple interest is the amount of money to be paid each period on a principal amount due.

How compounding works

If interest is not collected each period but allowed to accrue instead, then the accrued interest is added to the principal so that interest is charged on the preceding periods' interest as well as the unpaid principal.

This is known as compound interest. Compound interest is the amount of money to be paid on the unpaid balance of a loan, including unpaid principal and interest. In most states, consumer credit transactions typically use this method of computing interest.

For example, you borrow $100 at 12% annual interest compounded monthly. Although the interest is expressed as an annual rate, the period is actually a month.

Each month, 1% of the unpaid balance is added to the loan, so in the first month, the unpaid balance due is $101.00; in month two, $102.01; in month three, $103.03; and so forth, until at the end of the year, the amount owed is $100 principal and $12.68 interest.

While the annual percentage rate (APR) is 12%, the effective percentage rate (EPR) turns out to be 12.68%—somewhat higher.

The effective percentage rate is the annual simple interest rate that would have to be charged to equal the additional interest due to compounding.

Important terms used in calculating interest

The time value of money is the cost of money and is measured by the interest due over the loan period.

Here are some terms used in the computation of the time value of money. While we will not go into the formulas and computation, you should be familiar with these terms so you can use financial calculators effectively.

  • Present value (PV). The amount of money needed today to purchase certain goods.

  • Future value (FV). The amount of money at the end of the investment period equal to the present value plus accrued compound interest.

  • Number of periods (N). The total number of compounding periods in the term.

  • Rate (r). The annual interest rate divided by the number of compounding periods per year, sometimes referred to as "the discount."

  • Payments (PMT). Payments made to or from the investment during each compounding period, if any.

  • Beginning (BEG)/end (END). The time when payments are made. It can be either at the beginning of a compounding period (BEG) or at its end (END).

Using the example of $100 at 12% annual interest compounded monthly, the present value is $100. Its future value is $112.68. There are 12 compounding periods (N). The rate is 1% per period (12%/12). In this example, there are no other payments at the beginning or end of a compounding period.

Another example

Here is another example using a typical mortgage loan. A $100,000 (PV) loan at 6% compounded monthly (r = 6% / 12 = 0.5%) for 30 years (N = 30 x 12 = 360 periods) has a future value of $602,258. If payments of $599.55 for principal and interest are made at the end of each month, then the total loan repayment will be only $215,838 (599.55 x 360), since some loan principal and interest were paid each compounding period. With compound interest, it pays to make principal and interest payments each month.

Why the cost of money varies

The cost of money is measured by interest rates. Yet, we notice that interest rates seem to change. Let's explore why this happens.


How interest rates are determined

As they do for any other commodity, supply and demand affect the cost of money. Interest rates are determined by the supply of and demand for money. Inflation, too, is related to the supply and demand forces on money. Sometimes it is not clear which factor drives the rates, but there are clear connections.

High inflation = high demand for money = higher interest rates. Low inflation (or deflation) = low demand for money = lower interest rates. Likewise, on the supply side, a large supply of money = low inflation = low interest rates, and a small supply of money = high inflation = high interest rates. The sequence should not suggest cause and effect, but just the relationship.

The role of scarcity

The causes that produce each effect are more complex, and we would need to study monetary policy to get a better understanding of exactly how it works. Sometimes the cause of inflation is related to the abundance or scarcity of raw materials. This can occur naturally when natural resources are depleted or through human intervention if a manufacturer willfully reduces production of his or her product. Here are some examples:

  • If lumber becomes scarce because of reduced forest resources (due to fire or drought, for example), the cost of construction may rise as the cost of the dwindling lumber supply increases (natural cause).

  • In order to raise oil prices, oil producers cut back on drilling and refining operations to create a scarcity (human intervention).

If demand for goods exceeds their supply, prices rise (inflation), which lowers the money supply, which raises the cost of money. Sometimes the money supply is manipulated by the government to help control inflation. It is not always clear which is the cart and which is the horse.

A final thought

Interest rates vary because the cost of money changes, as do the supply and demand for money. Interest rates reflect both the cost due to inflation, which varies, and the risk premium associated with a potential borrower.

The cost of money and the economy

What are the effects of interest rates on the economy? Perhaps this question could also be stated: "What are the effects of the economy on interest rates?"

Both are valid questions, and either can affect the other. When economic forces such as supply and demand affect the amount of money available for investment in the economy, inflation may respond by rising or falling.

This in turn could affect real interest rate returns on investments. Companies and individuals who need cash are willing to pay more to borrow when cash is tight (high demand, low supply). If cash is plentiful, interest rates may fall to encourage borrowing (large supply, low demand). Interest rates may be controlled by the economy through lenders.

Unchecked, the free economy could spiral out of control, raising inflation, and reducing confidence in currency. Eventually a point would be reached where the process would swing in the other direction, but probably not before severe economic conditions occurred.

How monetary policy steps in

In order to avoid severe swings in the cost of money, government monetary policy applies financial brakes by controlling the supply of money.

Monetary policy attempts to control such economic factors as inflation and business growth by increasing or decreasing a nation's money supply through the manipulation of credit via interest rates. In the United States, this job falls to the Federal Reserve Board and the Federal Reserve Open Market Committee (collectively referred to as "the Fed").

Actions that the Fed can take

If the economy is slowing down and the Fed wants to encourage economic demand and spending, it will lower interest rates. This makes more money available to borrowers for investment or consumption of goods. If the Fed wishes to slow spending (to ward off inflation, for example), it will increase interest rates.

When the Fed raises or lowers the rate at which it charges financial institutions for short-term loans, called the discount rate, those institutions will raise or lower their interest rates in response to the Fed's action. The results have the same effect as that of the free economy, but are much more attenuated.

Summary of the cost of money

As long as the economy grows, we can expect inflation to erode the value of money over time. The rate at which money devalues over time is measured by the interest rates charged to borrow money, which also includes a risk premium. The interest rates are also referred to as the time value of money.

As the economy moves through its natural cycles of supply and demand, the cost of money may vary, thus affecting interest rates. Interest rates may also be manipulated by government monetary policy to keep inflation in check and to some degree control the economy.

This system of checks and balances helps maintain confidence in money. But it will probably always be true that "a dollar today is worth more than a dollar tomorrow."

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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