When calculating the future value of money in the world of investing and finance, understanding the time value of money is fundamental. The basic idea behind the time value of money is that a dollar today is worth more than the promise of earning a dollar in the future. Money in your hand today is worth more because of its potential for investment. The dollar gains value over time because of compound interest.
Compound Interest
When you deposit money in a savings account or some other type of investment, it earns interest on the entire amount deposited. After the amount earns interest for that year, the interest that was paid adds onto the original principal balance. The following year, the amount in the account earns interest again. This time, the money earns interest on the higher balance, which pays you even more interest that year. In this way, your account balance keeps growing over time.
Time Value of Money
The time value of money is a concept that deals with when you have money instead of how much you have. A dollar in today's terms is not as valuable as a dollar in the future. This is due to inflation and due to the fact that you could invest a dollar today and earn interest on it over time. When given the dollar sooner, it will gain more money for you when compared with taking the dollar later.
Present and Future Value
Terms such as present and future value of a sum of money apply to when investing in annuities and similar products. For example, when you have a stream of payments that you will receive over time, calculate the present value of those payments by using a discount rate. Calculate the future value of an amount of money based on how much it will earn in interest.
Investment Considerations
Once you understand the time value of money and compound interest, you will realize how important it is for you to start investing as soon as possible. If you are still young, getting started putting money aside for retirement can make a huge difference in the level of comfort you are able to enjoy once you reach retirement age. By simply getting started early, create a large retirement account by the time you reach 60 or 70.
References
- University of Illinois. "What is the Time Value of Money (TVM) and hoe does it impact my investment?" Accessed April 20, 2020.
- Corporate Finance Institute. "What is the Time Value of Money?" Accessed April 20, 2020.
- Financial Dictionary. "Price level." Accessed April 20, 2020.
- Credit.org. "What are Interest Rates & How Does Interest Work?" Accessed April 20, 2020.
- Financial Dictionary. "Discounted cash flow." Accessed April 20, 2020.
- Corporate Finance Institute. "Discounted Cash Flow DCF Formula, How to calculate net present value." Accessed April 20, 2020.
- Financial Dictionary. "Present value." Accessed April 20, 2020.
- Financial Dictionary. "Discounting." Accessed April 20, 2020.
- Study Finance. "Present Value Interest Factor." Accessed April 20, 2020.
- Calculators.org. "Present Value Calculator." Accessed April 20, 2020.
- Financial Dictionary. "Savings account." Accessed April 20, 2020.
- New York University. "A Primer on the Time Value of Money." Accessed April 20, 2020.
- Merriam-Webster. "Opportunity cost." Accessed April 20, 2020.
- Financial Dictionary. "Annual percentage rate." Accessed April 20, 2020.
Writer Bio
Luke Arthur has been writing professionally since 2004 on a number of different subjects. In addition to writing informative articles, he published a book, "Modern Day Parables," in 2008. Arthur holds a Bachelor of Science in business from Missouri State University.