Time Works Tirelessly, In Nature and In Finance

By Charles Carreon

To an economist, the time value of money is immediately evident. If I as you to lend me a dollar for a year, you will probably not think much of it. A dollar will be worth about the same in a year as it is worth today. And you can't think of much you'd do with it if you kept it, besides buy a beer, an ice cream bar, or a lotto ticket. If we increase the amount to $1,000, though, you'll realize that you could probably put that thousand dollars to work pretty nicely during the year ahead. Why should I have it, instead of you?

Hence comes the idea of charging interest to loan money. If I'm going to give you a thousand dollars, these days, chances are I'll have to borrow it from somebody else. Now think about it. If I have to borrow the money to lend it to you, what terms will I get? Let's say to borrow a thousand dollars for a year will cost me a hundred dollars. If I want to make you an interest free loan, but not a gift of any free money, I'll need to collect $1,100 from you in a year, so I won't lose any cash on the deal.


But I must consider — you may not pay me back. That's a risk. If I want to be compensated for that risk, I need to collect more from you in order to make it worth my while. Which is precisely the position the banks are in when they lend money. They borrow it from other banks, then they have to pay it back, with interest. So they try to lend it, first, to people and companies that will pay it back, and second, they try to collect a higher rate of interest from those who are more likely to not repay all of the money. That's why the government gets some of the lowest rate of interest when it borrows, and people with poor credit ratings pay more for their money.

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