What is the time value of money and why does it matter?
The time value of money – the idea that money received in the present is worth more than the same amount in the future because of its potential to be invested and to generate interest – is one of the tenets. founders of Western finance.
Let’s say you loaned your friend $ 2,000. Would you prefer that he reimburse you today or tomorrow? The logical choice would be today, as you will be able to use your money and the potential gains that come with it sooner.
What is the time value of money?
Money is worth more in the present than in the future because there is a opportunity cost to wait for it. In addition to your loss of use if you don’t get your hands on it right away, there is also inflation gradually eroding its value and purchasing power.
If you are going to part with your money for a period of time, you probably expect more money to be returned to you than what you started with. Whether you are lending or investing, the goal is to make a profit to compensate yourself for running out of your money for a period of time.
Suppose your friend offers to pay you back $ 2,000 today or $ 2,050 next year. You need to determine if you would make more than $ 50 over the next year by investing your money elsewhere before choosing to delay the payment. Other factors include your time preference (whether you need the money now or can wait a while to get it back) and whether you trust your friend to actually pay you back – another reason the money is worth more in the present: it may never materialize in the future. As the saying goes, “a bird in the hand is worth two in the bush”.
Why is the time value of money important?
The time value of money is important because, as the basis of Western finance, you will be using it in your day-to-day decision-making about consumption, business, and banking. All of these systems are based on the idea that lenders and investors collect interest paid by borrowers in order to maximize the time value of their money. Your job within this system is to limit the cost of money to you and increase the returns on your investments.
The concept is not new – it dates back to ancient times – and although, like Islamic finance, some cultures prohibit charging interest, their decisions are driven by similar monetary concepts.
Time value of money calculation formula
So how do you measure the time value of money? The formula takes the present value, then multiplies it by the compound interest for each of the payment periods, and takes into account the period over which the payments are made.
Formula: FV = PV x [ 1 + (i / n) ] ^ (next)
- (PV) Current value = What your money is worth right now.
- (VF) Future value = What your money will be worth in the future after it has (hopefully) earned interest.
- (I) Interest = Pay someone for the time their money is held.
- (N) Number of periods = Investment (or loan) period.
- (T) Number of years = Length of time the money is held
For example, if you start with a present value of $ 2,000 and invest it at 10% for one year, the future value is:
VF = $ 2,000 x (1 + (10% / 1) ^ (1 x 1) = $ 2,200
How Interest Rates Affect the Time Value of Money
Interest compensates some for the time she spends away from her money. Expressed as a percentage over a specific period of time, it is an expense or income that measures the value of money over time.
Usually, the more someone lends their money to another party, the higher the interest rate they charge. Shorter-term debt, such as a 15-year fixed mortgage, usually commands a lower rate than, say, a 30-year fixed rate mortgage.
Likewise, an interest-bearing investment such as a bank certificate of deposit usually pays a lower interest rate the shorter the term. If you agree to leave your money in the account longer, you are often rewarded with a higher interest rate.
There are several types of interest rates:
- Simple interest
- Compound interest
- Fixed interest rate
- Variable interest rate
Simple interest versus compound interest
Simple interest is shown in the example above: Just adding a 10% gain to $ 2,000 for a year is $ 2,200.
Compound interest, however, is calculated by adding interest accrued up to certain intervals during the term of the loan or investment in a way that can significantly increase future value. The time value of money is usually calculated with compound interest.
Using the same formula as above to calculate the same $ 2,000 at 10% for one year, but this time collecting the interest quarterly or four times a year, we get:
VC = VP x [ 1 + (i / n) ]^ (next)
This is calculated as follows: $ 2,000 x [1 + (10% / 4)] ^ (4 x 1) = $ 2,207.63
So that’s $ 7.63 more over the course of a year. Note that with compound interest, the future value is higher than it is when calculated with simple interest.
Fixed interest rates vs variable interest rates
When investing and borrowing, consumers often walk a delicate line in trying to maximize the time value of their money while avoiding too much risk.
As prices rise, many go into debt to afford houses, cars, vacations, and other big-ticket items. That’s why it’s important to take a close look at the type of interest you’re paying and how it changes over the long term, while looking to generate high returns to bolster the time value of your money.
If you have money invested in a Certificate of Deposit (CD), chances are it will earn you a fixed interest rate. Fixed rate refers to an interest rate that will not change over time. The opposite of this is a floating rate, which is an interest rate that varies according to the rise or fall of benchmark rates in the open market.
Simply calculated, if you invest $ 1,000 in a one-year CD at a fixed interest rate of 2%, the future value of your $ 1,000 will be $ 1,020. The time value of your $ 1,000 is 2%, or $ 20, in exchange for letting the bank keep your money for a year.
Opportunity cost and time value of money
The time value of money varies and involves an opportunity cost. This means that if you put the $ 1,000 in the CD, you risk forfeiting an opportunity to use the money as a good faith deposit on a home. Calculating the time value of your money should tell you that instead of investing at all, you should instead have paid off variable rate credit card debt that is costing you hundreds a month.
A variable rate instrument or loan periodically recalculates the interest paid or charged.
For example, a borrower might take out a low introductory rate 2% Variable Rate Mortgage (ARM), which will begin to adjust five years after the start of the loan to a spread on a benchmark like the Good. of the Treasury at one year. This means it adds the 2% to the treasury bill rate and that is the interest rate you pay on your loan for a year. The following year, it adjusts again according to the Treasury bill rates then, and so on until the loan matures.
Borrowers calculating the time value of money for these loans like to see the cost of interest postponed for several years. The loan is designed to attract borrowers who could not otherwise afford a fixed rate mortgage and who then place their hopes on interest rates that remain low once the interest rate begins to adjust to market value.
When this happens, the mortgage rate can suddenly rise based on the increase in interest rates since taking out the loan for the first time. There is no way to predict how much interest rates will rise in five years, making it impossible to calculate the time value of the money on the loan, which can be risky.
Savvy investors who plan to sell their home in the next few years do a TVM calculation to lower their borrowing costs with variable rate mortgages versus higher interest fixed rate loans. Taking advantage of the lower introductory rate, they don’t worry that the rate will be reset much higher because they won’t have the mortgage long enough to pay the higher rates.
Annual percentage rates and time value of money
One way for investors to guard against paying exorbitant interest rates is to defer or save for purchases they cannot pay in full on high-end credit cards. APR (annual percentage rates).
An APR is useful in TVM calculations because it is a rate that reflects what it will actually cost you to borrow money on a credit card, mortgage, or other loan on an annual basis. In addition to the interest rate, it takes into account the fees, points, and other costs associated with your debt. The APR makes it clear what the real cost is to you. Therefore, comparing APRs for different debt products can help you identify which ones have a lower total cost for your TVM calculation.
Consumers with a high time preference – which means they find it hard to wait to make desired purchases – fall prey to noticeably high credit card APRs of up to 25% and can end up in the market. position of only being able to afford minimum payments. With credit card debt, the time value of money is extremely high, often greater than the return on investment for individual investors.
The future value of the $ 5,000 vacation you paid on a 25% APR credit card, if it takes you a year to pay it off, is about $ 5,700. The credit card company makes $ 700 in just one year to lend you money to go on vacation. Before you incur credit card debt, consider that you are giving up the $ 700 you will be spending on interest and missing out on the potential future value of that money.