The time value of money is one such calculation that many people have difficulty with. It’s something you encounter every day but don’t think about until you need to use it again.
Understanding the time value of money can help you make more informed decisions about your future and understand the risks involved in any financial decision you make.
In this blog post, you’ll learn:
- What is the time value of the money?
- How to Calculate the Time Value of Money?
- What Is the Difference Between Present Value and Future Value?
- Why Does the Time Value of Money Matter?
So, what is the Time Value of Money? Let’s take a closer look…
What is the time value of the money?
The time value of money (also known as interest rate or discount factor) is the amount of time required to recoup the cost of an investment. It represents how much more valuable an investment becomes over time.
The time value of money is calculated using the time and nominal value of money. The nominal value of money is the amount that would be in a particular currency after it has been fully minted and issued. The nominal value may change with time, but its purchasing power remains constant.
For example, let’s say you have $100 to invest and you expect that in 5 years your total invested capital will be worth $500.
You can either invest your entire $100 or a small portion of it, depending on what’s most prudent at the moment.
If you invest 100% of your money and leave it there until it’s worth 500 in 5 years, then investing your entire capital is prudent because if you had left it there until it was worth 500 then you would have earned a 10% annual return.
This does not happen every time but over time an investment with a 10% return compounds into an amazing 50–60% average annual return (20–30% after taxes).
How to Calculate the Time Value of Money?
What Is the Difference Between Present Value and Future Value?
Present value is the time value of a series of cash flows that calculates the value of money today.
For example, if you want to find the value of $1,000 in one year, or the value of $2,500 in each month for the next two years, try finding the current value.
Alternatively, the future value is the concept of the time value of money, which involves determining the value of a series of cash flows at future points in time.
If you want to know what $500 will be worth 10 years from now, calculate the future value. If you want to know how much your retirement savings will be if he invests $250 a month for 10 years, you will also know its future value.
Why Does the Time Value of Money Matter?
The time value of money is important. Because, as the basis of Western finance, we use money for our daily consumption, business, and banking decisions.
All these schemes are based on the idea that the lender and the investor get the interest paid by the borrower to maximize the time value of money. Their job within this system is to limit the cost of money and increase the return on investment.
Bottom line
The value of money you have now is not the same as its value in the future and vice versa. Therefore, it is important to understand how the time value of money is calculated so that you can distinguish between valuable options offered today and options offered in the future.
Whenever there is an issue of money coming in and going out at a particular point in time, the time value of money should be considered.