The History of Time Value of Money
Posted by Emiliiarobinson on August 8th, 2019
The History of Time Value of Money
Time value of money is important in finance because money is more valued today than tomorrow. In the first place, when money is lent to an individual, the repayment is to be made in future. Therefore, there are risks associated with this lending. There are chances that money will not be repaid. These risks can be compensated for if interest is paid on the loans. The money lend could have been used for other purposes to benefit the owner. This means that it is reasonable to compensate the owner for the profits forgone when money is lent. For many financial transactions to take place, time value of money becomes an important consideration.
The cost of loans that is paid in terms of interest shows two things. First, it represents the price of using funds that are borrowed from another individual. Secondly, it reflects the risks that are associated with the lending process. People would not be willing to give loans if they do not benefit in any way. Investors would not risk their money in investing if there are no returns. All these returns come along due to the time value of money. The riskier the lending or the investment, the more interest should be paid. The longer the time taken to repay the loan, the more interest is to be paid to compensate the owner of the funds.
Lending with interest originated from Babylon in 2000 BC. People usually borrowed grains that they planted in their farms. Some borrowed grains to cook when they had no enough in their homes. An interest was usually paid for this service. During the time, people were required to pay an interest that ranged from 6 to 25 percent in a year. This motivated those who were willing to lend.
John Calvin came up with a theory to explain the importance of interest rates in the year 1536. According to the theory, only poor people should be lent money freely. His argument was based on a statement by Jesus that people should lend without expectation of any return. In this case, Calvin argued that poor people should not pay interest but should repay the loans that are lent to them. On the other hand, business people who wished to run businesses can obtain loans that should be paid with interest. He argued that it is fair that business people pay interest from the profits they earn after using borrowed funds. He differentiated two types of lending. There is lending that is meant to exploit the borrowers by charging them high interest rates. This is what he called “biting loans”. There are other reasonable loans that are fair. These loans demand reasonable interest rates. Calvin discouraged biting loans.
During the time of John Calvin, various groups and people opposed the issue of lending at interest rates. Christians, Protestants, and Muslim were strongly against lending with an aim of making profit. However, the trend changed in the 17th century. At this time, Protestants and Christians appreciated that some types of lending is acceptable. The group argued that the legality of the interest depends of the agreement between the lender and the loaned party. This means that interests were acceptable if they were agreed upon between the lender and the borrower.
Late in 18th century, lending was becoming a normal thing. Catholics for example argued that those who were lending their monies with an interest were not sinning as long as the interests they charged were reasonable.
In the 19th century, capitalism began to spread. Lending was acceptable by many countries and groups. Many laws were passed at this time to regulate lending activities. This is when time value of money became an issue of importance since the lending system had developed greatly. Countries like the United States allowed their states to regulate interest rates charged in their countries. Previously, laws were in place to prevent any acts of usury in the United States. However, these laws were reviewed to allow lending at a given interest rate.
The method of computing interest rates has developed through history. Initially, simple interest rate formula was used. In this case, individuals were required to pay the amount borrowed plus the interest charged. However, compound interest rate formula has also been used to solve the problem of time value of money. In this case, interest that is not paid in a given month is charged some interest too. This means that interest earns interest; hence the amount to be paid increases.
The issue of time value of money has been dealt with in various ways. The amounts borrowed and interest is paid in different methods. Some people pay part of principle and interest for the period each month. This means that interest to be paid keep on reducing as principle reduces. Another method is whereby, people pay interest only each month and the principle is paid at the end of a given period. In this case, interest is constant throughout the month. Another method involves no payments during the months. The accrued interest and principle is paid at the end of period. These methods of dealing with the problem depend on the agreement between the lenders and borrowers.
The development of interest and the theory of time value of money have been of importance in the development of banks. Banks have grown to serve the financial needs of people with the expectation that they will receive interest that form their source of profits. People invest with the banks and receive interest from the money they save. The banks, on the other hand, risk the money they have with the hope of receiving interest rates. Those who receive loans are expected to repay more than they have borrowed since the value of money today is greater than its same value the next day. The banks, therefore, serve as an intermediary between lenders and borrowers so that an organized borrowing is available. Business organizations are able to borrow the funds they need easily and repay them.
Both parties involved in lending process benefit from the theory of time value of money. People are only willing to lend their money as long as they benefit from their lending activity. Interest rates have led to large amounts of funds available for lending purposes. People have been able to access funds they need within a short period. The lenders are compensated from the risks associated with the lending process since they receive interest on the monies they have deposited with their banks.
The time value of money and the issue of interest rate have developed greatly in history. The benefits associated with time value of money has facilitated this development. People and organizations has benefited from these developments. People have also seen the importance of time value of money with time and have finally accepted that lending at an interest is not a sin. Lending at interest has become a normal thing to all people. Even though Muslims still believe that lending at interest is unacceptable, they have their own banks that provide them the financial services they need. It can be therefore concluded that time value of money has led to major developments in the financial sector which has been of benefit to many people. The developments have taken a long time whereby different groups of people have been accepting the issue with time.
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