The Time Value of Money in Divorce
Posted on January 27,2015 in Divorce
Suppose a stranger offered you $100 now or $100 in a year, which would you choose? Almost everyone would take the $100 now because of an intuitive understanding of something economists refer to as the “time value of money.” Money now is worth more than the same amount of money later, not just in the sense that instant gratification is nice, but in terms of actual financial worth.
Understanding why this is true and how to compare money across time can be important for divorce cases. After all, a person's intuition is enough to know that $100 is better than $100 later, but what about $100 now or $150 in a year? More realistically, what about a decreased child support payment in exchange for paying a greater share of the child's college expenses?
Why Money's Value Changes over Time
Money's value changes over time for a lot of reasons that can all be broken down into three categories. The first category is inflation. Over time, the amount of money it costs to equal the same amount of purchasing power increases. This is why people used to be able to get gas for a quarter and a bottle of coke for a nickel.
The second category is lost profits. Money that is not spent has the ability to be used for a profit. The most obvious way that this happens is through investments in stocks and bonds, but even people who do not play the market still benefit from this. Buying a house, leaving money in a savings account, even paying down debt are all profitable uses of money because there is some return on that use of the money.
The final category is risk. There is a risk that money not paid immediately will never be paid. Maybe the other spouse will default. Maybe they will lose their job and be unable to afford it. There are a host of risks that make it less likely that the money will be paid as time passes.
This is not to say that it always makes sense to take the money up front. It just means that people need to understand what the value of future money is in comparison to present money.
Calculating the Time Value of Money
The easiest way to calculate the time value of money is through the use of an online calculator like this one. It takes the actual amount of money, the amount of time, and the interest rate, and returns either the future or present value. However, doing this well requires an understanding of the right interest rate to use. The interest rate is a percentage that takes into account all three of the above factors. For example, if there is an especially high risk that the other spouse will default, then the interest rate would rise. Choosing the right interest rate is a complex task that may require financial experience to help capture all the particulars of someone's financial situation.
Fortunately, divorce lawyers are faced with these sort of questions on a daily basis. If you are considering divorce and have questions about the practical consequences of a divorce, contact an experienced DuPage County divorce attorney today.
