What is Time Value of Money?
Time value of money, often abbreviated as TVM, is a core concept that every investor should understand. It means that money today is worth more than that same money at some point in the future. This is due to the opportunity cost of not having the money to use on other investments now.
Money now or money later
Would you choose $1000 now or $1000 in a year? Unless you are crazy you would take the cash now. What if I gave you the option of $1000 now or $1200 in two years? This makes the decision quite a bit tougher.
Don’t forget that a lot can happen in 2 years. You may need the $1000 for an emergency. You could also take it and invest it for those two years.
The point to take away from this is that money now is worth more than money later. The further into the future you go the less the money is worth. You can use this to compare the value of competing financial assets that you might choose to invest in.
The formula for TVM is pretty basic to finance. It allows you to calculate either the future value of money at a point in time or the present value of a future payment. You can calculate these values out yourself or let the DollarTrak App do the work for you. The basic formula is:
future = present * ( 1 + (interest / periods) ) (periods * time)
The variables are:
- future – future value
- present – present value
- interest – interest rate(as a decimal, .10 is 10%)
- periods – count of compounding periods per year(monthly is 12)
- time – time as number of years it makes payments for
Taking the example above you could compare the two scenarios presented to you to determine which one was really the better investment. You only need to know your required rate of return. Let’s assume here that you require a 10% return for this type of investment and it compounds monthly.
future = $1,000 x (1 + (.10 / 12)) ^ (12 x 2) = $1,220.39
So it turns out that with a 10% required return, the $1,000 up front payment is better than the $1,200 payment in two years.
The time value of money is an important concept that allows you to normalize the value of different investment options so that they can be compared. It is a core concept in finance that every investor should understand. If the calculations are too much for you then just try and remember the idea that money today is worth more than money tomorrow. How much more depends on your required rate of return.