The time value of money (TVM) is a useful tool in helping you understand the worth of money in relation to time. It is a formula often used by investors to better understand the value of money as it compares to its value in the future. Below we’ll go over the in’s and out’s of the TVM and how you can use it to understand the effect time has on the value of your money.
What Is the Time Value of Money?
The basic principle of the time value of money is that money is worth more in the present than it is in the future, because money you have now has the potential to earn. This is due largely in part to inflation. If you think about it, $1,000 in 1999 could buy you more than it could 20 years later, in 2019. And having a $1,000 today will theoretically buy you more than having $1,000 five years from now. With that in mind, the time value of money formula can help you determine the present value of the money you have today and how much it could be worth in the future.
With investing, however, there is a certain amount of risk you should consider as you use the time value of money. For example, saying you’ll take that $1,000 and invest it in your favorite company that’s expected to provide a 5% return each year is not guaranteed. Instead, with this any investment, you’re accepting the risk of losing money for the chance to beat inflation and increase the future value of your money.
Why Is the Time Value of Money Important?
The time value of money is important because it allows investors to make a more informed decision about what to do with their money. The TVM can help you understand which option may be best based on interest, inflation, risk and return. It can also be used to help you understand how much money to save in an account if you have a certain goal in mind, such as saving $20,000 in five years if the account earns 3 percent compound interest each year.
The Importance of Compounding Interest
If the basic idea of the TVM is that money is worth more today than it is tomorrow, you’d think it’d be wiser to spend it now rather than save it for later - but we know that isn’t always the case. While inflation works against you, meaning it makes your dollar worth less tomorrow than today, compound interest can work in your favor to elevate the value of your present dollar tomorrow.
With compounding interest, the amount of money you’re earning interest on grows in each compounding period. For example, if you have $1,000 and it earns 10% compounding interest every year for five years, the compounding period would be one year. While that means in the first you’ve earned $100 in interest (10% of $1,000), in that second year you’re actually earning interest on the total amount from the previous compounding period, which would be $1,100 (the original $1,000 plus the $110 in interest earned in year one). By the end of year two, you’d have earned $1,210 ($1,100 plus $110 in interest). If you keep going until the end of year five, you would have turned that $1,000 into approximately $1,610. If we consider that the highest inflation rate over the last 10 years was three percent, then in this scenario, choosing to invest your present money using compounding interest leaves you with a favorable and profitable outcome when compared to not investing it at all.1
The Time Value of Money Formula
The following make up the components of the TVM:
PV: present value
FV: future value
R: rate of growth or interest rate
N: number of periods (typically measured in years or months)
Using those values, this is the time value of money formula:
FV = PV x (1+I)^N
Or, if you’d like to understand the present value of future earnings, you could use:
PV = FV / (1+I)^N
As we mentioned before, these formulas can be used in different circumstances to help investors or savers understand the value of money today in relation to its earning potential in the future. The TVM is an important piece of understanding the affect inflation has on our money and why investing early can help increase the value of your dollar by giving it time to grow and beat inflation rates.
This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.