Understanding the Time Value of Money
You've probably heard that time is money and money is time. Well, it's true! In financial circles, there's something called the "time value of money." The time value of money is simply a concept to assign a worth to money based on different periods of time. For example, we can ask if you're better off having $1,000 today or $3,000 in twelve years. Which is more valuable? To be able to answer that question, you have to be able to calculate the future value of $1,000 over a twelve-year span.
Let's examine the concept of future value. We'll use our example of $1,000 now vs. $3,000 in 12 years. And let's assume that you expect to make 8% on your investments.
Figuring Future Value (FV):
Equation: FV = Original Amount x (1 + interest rate)time
Plug in your numbers: FV = $1,000 x (1 + 0.08)12
Calculate Answer: FV = $2,518.17
This means that $3,000 in twelve years is more valuable because $1,000 now would only be worth $2,518.17 in twelve years.
Present Value
Just as money has a future value, it also has a present value. Using this concept, you can also solve the dilemma above by calculating the present value of the $3,000 that you'd receive twelve years in the future.
Present value looks at an amount of money to be received in the future and determines what it would be worth now.
Let's imagine you were going to receive $5,000 in five years. What would that be worth now? This is really just the reverse of finding the future value. Let's use an interest rate of 7%.
Figuring Present Value (PV)
Equation: PV = FV / (1+interest rate)time
Plug in Your Numbers: PV = $5,000 / (1+0.07)5
Calculate Answer: PV = $3,564.93
This means that $3,564.93 today would have the same value as $5,000 earned in five years.
Don't let these equations intimidate you. Calculators and spreadsheets make them a snap. Financial math is often quite simple, even if the exponents look daunting.
Now that you have these equations at hand, let's see what they can do for you personally. To start with, you could calculate what your investments will be worth in a certain number of years. You could also figure out what your savings account would be worth 20 years from now.
Let's suppose you wanted to have a million dollars in the bank in 25 years. You'd want to calculate how much money you would need now to make that happen in the given period of time. You could also look at the amount of money required to make a million dollars sooner than that.
Here are some of the most common situations where these calculations would be useful:
Student loans
Savings accounts
Credit cards
Mortgage payments
Retirement planning
Investments
Retirement planning is probably the most common activity for using these concepts. Try playing with a few examples from your own life. Figure out how much your 401k would be worth in the future if you never deposited another dime in the account. Investigate the future value of all your retirement investments.
However you go about using these equations, now you can calculate exactly what time is really worth to you, in terms of money. By utilizing the concepts of future value and present value, you'll never need to be confused again when you're comparing financial options. Dig into the math and apply it to you own life. There's no better way to learn.