When financial planning, creating a budget, or investing you may constantly hear about the time value of money concept. To create the best financial future for yourself, it is very helpful to understand what this phrase means and how it affects you. In the following article, we will go over what the time value of money is and how you can calculate it for yourself.
What is the time value of money?
The time value of money (TVM) is a concept that means your money is worth more now than in the future. The difference between the values is the earning potential that your money has in the present. For example, it is better to have $10,000 now rather than receiving it in ten years. If you receive that money now, you can invest it and grow it to an even larger sum. You could be earning interest on that money, which could compound over the 10 years. Also from a utility perspective, the money will be more useful to you if you have the money now. Most rational investors and savers will opt to have the money sooner because you can either use it or invest it to gain more benefits.
The TVM Formula
To help you find the time value of your money, we will go over the basic TVM formula. Even if you do not want to calculate it yourself, knowing the basic formula will help you understand the concept as a whole. For the formula, you will need to know the following variables:
- FV = Future Value of Money
- PV = Present Value of Money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
Using these variables, you can plug them into the following equation the calculate the TVM:
FV = PV x [1 + (i/n)]^(n x t)
Once you understand the formula, the difficult part is coming up with the variables. Below we will go over what each one means and how you can find it.
- Future Value - The future value is how much money you will have in the future if you take it an invest it.
- Present Value - This is simply how much money you have now and are willing to invest.
- Interest Rate - This is the value at which you can invest your money and have it compound over the years. It is typically recommended to use the treasury bond yield for the same duration as your investment. This can be found at the US Treasury website here.
- Compound periods - This simply means how many times of year you will be earning interest. It can be monthly (12), quarterly (4), semiannual (2), or annual (1).
- Years - This is how long you plan to invest your money, or how far into the future you are trying to determine what your money will be worth.
The time value of money is a concept that is much more simple than it may seem. Once you can understand how it is calculated, you will be able to find the value of your own money by yourself. You will then be able to become a more effective investor and create long-term financial gains.