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The time value of money means that money is worth more now than in the future because of its potential growth and earning power over time. In other words, receiving a dollar today is more valuable than receiving a dollar in the future.
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 idea that receiving a given amount of money today is more valuable than receiving the same amount in the future due to its potential earning capacity. If you invest $100 today, that money can start earning interest, for example. In the future, your initial investment will be worth more than $100 due to the earnings on that investment. So receiving $100 today is more valuable than receiving the same amount in the future. The same idea can be expressed alternatively using inflation, as the value of $100 buys fewer and fewer goods over time due to rising costs.
Understanding the time value of money can help you with personal finance, such as decisions regarding your salary, loans and investments. For instance, if an investment offered you $15,000 today or $15,750 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 $750 – just five percent. And, your purchasing power is likely greater now than in three years.
In short, the time value of money is the expected return – or cost – of that money over a given time period.
How is the time value of money calculated?
You can calculate the time value of money using the following formula. Bankrate has an online calculator that’ll do the math for you.
FV=PV(1+i/n)n*t
Alternatively, you might see the formula inverted to calculate the net present value of future income:
PV=FV(1+i/n)n*t
Key:
FV: Future value of money. More on that below.
PV: Present value of money, also explained further on.
i: Interest rate or the discount rate, which is a risk-free rate of return or an inflation rate.
n: Number of compounding periods of interest per year.
t: Number of years.
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.
FV=$10,000(1+3%/1)12*5
So for a savings account with a 3 percent interest rate that compounds annually – that’s the second and third “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 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 finance part of the purchase.
The same concept applies to increasing retirement contributions as opposed to spending the money today. So you can calculate how much you can expect to have in retirement and what the true cost of purchasing that new item is in terms of the money you’re giving up in the future. For example, the future value in 10 years of a $25,000 car today assuming 5 percent compounded annually is $40,722. That car suddenly looks a lot more expensive.
What is the present value of money?
The same principle works in reverse, allowing you to convert the future value of money into the present value today. For example, if you received $500 in three years, that’s equivalent to $431.92 today, if you can receive 5 percent interest annually on it. So if you were presented with the choice to receive $431.92 today or $500 in three years, you might be ambivalent about the choice if you know you can earn 5 percent on your money over that time period.
The expected return you might receive over time – what experts call the discount rate – has a big impact on the present value:
- A higher discount rate means the present value of a future sum of money is lower.
- A lower discount rate means the present value of a future sum of money is higher.
For example, using the $500 example from before, if you could earn 8 percent on your money over that three-year period, then the present value of that money is just $396.92.
Winners of the lottery may think about present value when they’re deciding whether to take a lump sum payment today or payments over a longer period. If they can earn more than the discount rate that lottery officials use to calculate the lump sum payout, it may be worthwhile for winners to take the lump sum and invest it themselves. So they may opt for the lower total payout.
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, given a specific return.
These concepts are just different ways to view the time value of money.
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 can be used when a company is considering whether to invest in developing a new product development, acquiring new business equipment or facilities or establishing 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 amount of time.
How does inflation impact the time value of money?
Your purchasing power decreases with inflation, so a given amount of money today will not buy as much in the future. 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 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.
Bottom line
There’s a reason the saying “time is 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 the only factor in decision-making, it’s a valuable concept to keep in mind.
