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 its 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 about why it’s so. The underlying principle is that if you received the money today, you’ll be able to use your money and the potential gains that come with it, sooner.
If I have shaken up your financial reasoning, let me explain further the time value of the 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 stand out, 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 worthless 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