"Time Value of Money Applies to Income Flows to Past and Future"
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If you win the jackpot in many state lotteries, you are given the choice to take your money divided into annual installments spread over 20 to 25 years (rules are different in each state) or all at once.
This illustrates interest as the time value of money and the related concepts of discounting and the present value of money or a stream of income.
I'm sure many lotto jackpot winners are upset to learn that if they want all their winnings all at once, they will NOT get the advertised jackpot. The amount placed into their hand will be right around half the jackpot -- and they'll have to pay taxes on that, but this article's not about taxes.
Interest . . . Because Time is Money
The lottery rules state that if you want the full jackpot, you must take it in annual installments spread over 20 to 25 years.
Of course, over the course of those 20 to 25 years, the state is holding a fund of money they've invested, and they pay you the annual payments out of the fund of invested money.
Money in your hands now is worth more than annual installments spread over 20 to 25 years, so you must accept a lesser amount if you want it all now.
When you win a lotto jackpot, you've officially won a stream of income that lasts 20 to 25 years. Let's say you won a big jackpot of $100 million dollars and it's paid out over 25 years in your state. That means the state will pay you $4 million a year for 25 years.
Nothing to complain about.
If you want all your money NOW -- you'll probably get about half, or $50 million.
That makes $50 million the present value of $4 million a year for 25 years.
The total of the annual payments is twice as high, but you have to wait the full 25 years to get it all.
Financial professionals say that the income stream of the lottery has been discounted to $50 million, and that's the present value.
Lotteries Pay You a Lump Sum Based on the Current Discount Rate
If you're ever faced with this lucky choice, ask the lottery officials what the discount rate is
That's the percentage which they're using to discount your payment. They are calculating the present value based on some legally defined percentage.
It's like the interest you earn by putting money into a savings account. If the account pays 1%, the money you put in today is worth less than if the account pays 10% interest.
The state lottery officials are using some interest rate to discount your payments. That's a rate which they assume the income stream will be worth over the course of 25 years.
The higher the rate, the lower the present value of what they'll pay you. And the more financially advantageous it is to you to take the annual payments instead of the lump sum. And that's partly because the higher the rate the state is using, the more difficult it will be for you to exceed it with your own investments.
Of course, other factors are really more important. Many people take the lump sum because they want all that money NOW. If they can invest it for a good return, that's a good option.
If You Win the Lottery, Live On Its Time Value
However, many of them blow through the money and wind up bankrupt in a few years -- with no sympathy from me, by the way
So unless you're really sure of your self-discipline, take the annual payments, but save and invest at least 25% of that payment, each and every year, so that when the 25 years is up, you'll have a big chunk of money invested and earning you enough money to keep you living the lifestyle to which you've become accustomed.
You don't want to be out looking for a job in 25 years -- few prospective employers will want to hire someone who's been living on Easy Street for the past generation, but blew all their money.
And if you'll be old enough to draw Social Security, you sure don't want to depend on what you'll get with a 25 year gap in your earnings record.
Invest Your Lotto Jackpot for Income, and Live On that
Still, if you are disciplined, and use the lottery lump sum to pay off all your debts and then invest the rest in good income investments, you can live well on that for the rest of your life
You won't even remember to apply for Social Security when you get that old -- you'll be too busy skiing in Switzerland.
For the 99.99999999999999% of us who will never win a lottery jackpot, I wanted you to learn about discounting and the present value of money.
These concepts become extremely important when we talk about investing in notes.
In Financial Theory, an Investment is Worth the Present Value of the Future Stream of Income, Discounted by Prevailing Interest Rate
(Which of course will change in the future, but that's unpredictable.)
Therefore, if you'd pay $10 for an investment that will pay you $1 a year for twenty years, you should be willing to pay $20 for one that will pay you $2 a year for twenty years.
All other things being equal (which of course they never are -- life being as complicated as it is.)
Still, I want you to understand that money has a time value, and if you pay more for an investment than it's worth, you're losing money.
And the single number one way that people lose money with fixed income investments is the force that is right now eroding the value of our money over time: Inflation
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