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The time value of money concept is all about how money is worth more now than in the future because of its potential growth and earning power.
Here’s more about the concept, how to calculate the time value of money and why it might be an important tool for financial decision making.
What is the time value of money?
The time value of money is the concept that money is worth more in the present than in the future due to its potential earning capacity, or alternatively, to inflation. If you invest $100 today, that money can start earning interest or dividends. In the future, your initial investment will be worth more than $100 due to the earnings on that investment. In this way, money can be said to have a time value.
Understanding the time value of money can help you with personal finance, such as decisions regarding your salary, loans and investments. For instance, if your boss offered you $15,000 today or $15,800 in three years, what would you do? While it may seem worth waiting for the higher payout, taking the money today is probably the better bet. You can invest it and potentially earn far more than $800. And, your purchasing power is likely greater now than in two years.
How is the time value of money calculated?
You can calculate the time value of money using the following formula. Or, there are several online calculators that’ll do the math for you.
Alternatively, you might see the formula inverted to calculate the net present value of future income:
The formula comes in handy when you want to determine the future value of an investment. For example, say you have $10,000 and you want to invest the money for five years. To find the future value of the investment, you’d plug those numbers plus the interest rate and compounding periods into the formula.
So for a savings account with a 3 percent interest rate that compounds annually (that’s the “1” in the formula above), you’d have $11,592.74 in five years.
What is the future value of money?
The future value of money is the amount of money you’ll have in the future, assuming you invest a specific amount of money in an account with a certain interest rate. Investors can use this calculation to compare different investments, such as a high-yield savings account versus stocks. The math can become tricky because it’s based on the assumption of stable growth. For accounts with a set interest rate and one, up-front payment, the formula is simpler, as you can see from the above example.
When we get into compounded annual interest, the formula becomes more complicated because you have to account for the interest rate applying to the cumulative balance. A practical, personal finance application of the future value of money can be using the concept to help decide whether it’s better to put no money down on an item — such as a car — or to pay discount points to get a lower mortgage interest rate. The same concept applies to increasing retirement contributions. You can calculate how much you can expect to have in retirement or a high-yield savings account.
What is the present value of money?
The concept of present value states that a sum of money received today is worth more than the same sum received in the future. For example, $500 today could be invested in an account earning 5 percent interest. If that same $500 is received three years in the future instead of now, you’d lose out on potential growth from interest in the interim years.
Investors use present value principles to compare the value of assets with different time horizons as well as to determine if the price of an investment is reasonable. More specifically, investors use the concept to evaluate the flow of future payments to calculate the current value. Say you have to pay $100 a month on a $10,000 loan over 10 years — what is the present value of the future payments? To find the answer, you’d discount the future payments back to the present using a discount rate, which is a risk-free rate of return (often assumed to be U.S. Treasury securities of comparable maturities, such as the high yield on a 10-year Treasury Note in this case, or an inflation rate). How you choose the discount rate can have a big impact on the present value. If the discount rate is less than the interest rate, the present value in this example will be greater than $10,000. If the discount rate is greater, the present value will be lower. Lastly, other applications of the present value concept include calculating income from mortgages, loans and other long-term assets.
What is the difference between present value and future value?
These two terms help you understand what your money is worth now versus later. Future value is the value of a sum of money, given a certain rate of growth, at a specific future date. For example, the amount you’ll have in five years after investing $1,000 in a savings account today. Present value is a similar concept, but instead tells you how much you’d need in today’s dollars to yield a specific amount in the future.
How does the time value of money factor into decision-making?
The time value of money is useful for a number of financial decisions. Here are some of the most common ones you may come across:
- Evaluating whether it’s better to purchase or rent a home.
- Deciding how much to save for retirement.
- Deciding whether to pay off loans or invest.
- Deciding whether to purchase or lease a car or other equipment, including whether to pursue a cash discount or no money down payment.
For businesses, the time value of money concept can be used when a company is considering whether to invest in new product development, acquire new business equipment or facilities or establish credit terms for the sale of products or services.
For example, companies will use a formula to help determine whether to offer a 30-, 60- or 90-day credit term for the sale of products or services. The formula factors in the present value of money, the expected return on the investment and the number of years to be taken into consideration.
How does inflation impact the time value of money?
Your purchasing power decreases with inflation. Think about it this way: if you set aside $100 for groceries and wait five years to use it, you’ll come back from the store with fewer bags than if you shopped immediately. Inflation has a negative effect on the time value of money because it reduces its purchasing power. In other words, you’re able to buy less with the same amount of money.
When you calculate projections for future returns, remember to factor in the rate of inflation to determine the real return on an investment. If the inflation rate is greater than the rate of return, the purchasing power of money will decrease.
There’s a reason the saying “time equals money” is popular. Knowing the time value of money can help you weigh the costs and benefits of various investment and financial options. While it’s not a one-stop-shop for decision-making, it’s a valuable concept to keep in mind.