Time Value of Money: Making the most with your Money

Time Value of Money

Time value of money might sound confusing, but it’s the concept that money is worth more today than in the future because of it’s potential to be invested and earn interest. This core principle of finance holds that money can earn interest, therefore, any amount of money is worth more the sooner it is received.

Let’s say you lent your friend $500. Would you rather they repaid you today, tomorrow, or 6 months from now? The logical choice would be today, however, you might be confused why it’s so. The underlying principle is that if you received the money today, you’ll be able to use your money and potential gains that come with it, sooner.

If I have shaken-up your financial reasoning, let me explain further the time value of money concept.

What is the Time Value of Money?

As I stated earlier, money is worth more in the present than in the future. But, why? There are a few factors but three standout, opportunity cost, inflation, and interest.

Opportunity cost is making a choice and considering the trade-offs. In essence, you’re analyzing what you are gaining as well as what you may be giving up. Referencing my earlier example of lending your friend $500. There is a trade-off to consider, lend them $500 with hopes of recouping the money in the future or invest it to earn interest. One earns you money, the other loses you money because that $500 is worth less in the future.

Then there’s inflation, which gradually erodes the value and purchasing power of money. As it stands, the average annual inflation rate is 3.22% according to 2020 data.

When you part with your money, you expect to receive a larger sum back. How do we solve that? Interest. Whether you’re lending or investing, the goal is to make a return on your investment for going without your money for a while.

Opportunity Cost Example

Let’s take that friend you loaned $500 to, they want to pay you back today or $600 next year. You must consider whether you’d earn more than $100 which is 20% earned interest over the next year by investing your money elsewhere.

There are other factors to consider, such as whether you need the money right now or can wait. Do you trust your friend to repay you? Another reason why money is worth more in the present, it may never materialize in the future. As the saying goes, “a bird in the hand is worth two in the bush.”

Calculating the Time Value of Money

So how do you measure the time value of money? The formula takes the present value, then multiplies it by the interest for each of the payment periods and factors in the time period over which the payments are made.

Formula: FV = PV x [ 1 + (i / n) ] ^(n x t)

(PV) Present Value = What your money is worth right now.
(FV) Future Value = What your money will be worth in the future.
(I) Interest = Paying someone for the time their money is held.
(N) Number of Periods = Investment (or loan) period.
(T) Number of Years = Amount of time money is held.

For example, if you start with a present value of $2,000 and invest it at 10% for one year, then the future value is: FV = $2,000 x (1 + (10% / 1) ^ (1 x 1) = $2,200

Interest Rates affecting the Time Value of Money

Interest is how we compensate a person, business, bank, etc. for the time they spend away from their money. Expressed as a percentage over a specific period of time, it’s a charge of money’s value over time.

Usually, the longer someone lends their money to another person, the higher the interest rate they charge. Shorter duration debt, like a 15-year fixed mortgage, usually commands a lower rate than, say a 30-year fixed-rate mortgage.

Likewise, an interest-bearing investment like a bank certificate of deposit usually pays a lower interest rate for a shorter term. If you commit your money to a longer-term, you’re often rewarded with a higher interest rate. There are several different types of interest rates:

Simple Interest
Compound Interest
Fixed Interest Rate
Variable Interest Rate

The Power of Compounding

Compound interest refers to interest payments that are made on the sum of the original principal and the previously paid interest. An easier way to think of compound interest is that is it “interest on interest,” where the amount that the interest payment is based on changes in each period, rather than being fixed at the original principal amount.

Compounding interest is by far the most powerful tool for investors and the number of compounding periods can have a drastic effect on the time value of money calculations.

Let’s look at a $10,000 investment. If the number of compounding periods is increased to quarterly, monthly or daily, the ending future value calculations are:

Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038
Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047
Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052

The sooner you put your money to work the better. Don’t let your money lose value by parking it in a shoebox under your bed. If you have a savings account, make sure it’s a high-yield savings account. If you’re “thinking” about investing, stop thinking and do because each day your money is losing out on an opportunity.