How Is Compound Interest Related to the Time Value of Money?

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.