The time value of money (TVM) is a basic financial concept that shows how the money you have today is worth more than the equal amount of money at some point in the future. In other words, "a dollar today is worth more than a dollar tomorrow."
The core principle of the concept is that the money you have now can start making you more money for later on. Therefore, the earlier the money is received, the more it is worth over time. The later it is received, that lost time means lost investment earnings.
Let's illustrate it this way. Say someone has the opportunity to be given $100,000 today, or be given $10,000 every year for 10 years. Which is the better option? According to TVM, it would be better to receive the $100,000 at once. Putting aside tax considerations, the money received all at once gives you the ability to put all the money to work via an interest bearing account, stocks, or real estate, or some other investment asset. After 10 years, the amount of growth on the whole amount would be worth more than if it was received in increments over 10 years.
How it works
The formula goes like this:
FV = PV * ( 1 + i ) ^n
FV = Future value of money
PV = Present value of money
i = Interest rate per period
n = Number of periods
So in the example above let's say someone chose to split the payments over 10 years. They still decided to put the money to work at each interval and received a 5% annual return. Here is how much it would be worth after the 10 years.
As you can see the ending balance would be $132,067.87 if they put the $10,000 each year in an account earning 5% interest. But now let's say they took the whole $100,000 at once and again were able to get a 5% return on their investment. How much will it be in ten years?
FV = ( PV ) $100,000 x ( 1 + 0.05 interest )^10 years
FV = $162,889.46
So in the same amount of time, the $100,000 all at once is worth over $30,000 more in 10 years than receiving it in increments over 10 years (assuming the same annual return). This is the time value of money (TVM) at work. The old saying "time is money," is quite literally true.
Why is the time value of money important?
Understanding this concept can help with real-world problems. For example, TVM can help you with how to prioritize paying off debt and building up savings and investment accounts. It also can help with understanding inflation and how to plan for it. For example, 20 years ago you could go to McDonald's and buy a combo meal for $5. Can the same $5 buy you a burger, fries, and coke today? Currently it might get you just the burger. The point is the same $5 doesn't go as far as it once did.
Unsecured debt (like credit card debt) is one important example of how the TVM formula works. The interest owed on the money borrowed compounds each month, making the debt increase unless the principal is aggressively paid down. The longer it takes to pay, the more paid to the bank, and the less you keep for yourself. Those interest rates are usually in the high teens percentage rate or more, really racking up interest expense over time. This can help you understand why staying out of unsecured debt is so important, and inform your decision making.
Investing is the best way to combat inflation and provide for your future self. Of course, there is always some risk to investing, whether it is in real estate, stocks, or a debt security like a bond. But there is a definite opportunity risk for not investing. Money sitting around doing nothing is money losing value. The longer it sits idly, the more it loses, and the less it's worth in the future. On the other hand, the longer it's invested, the better chance you have to put the power of TVM to work in your favor.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. Our investment philosophy takes a forward-looking approach that may not transpire. The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investing involves risk and you may lose your principal.