The Importance of Time Value of Money
You’ve probably heard about the importance of time value of money. But do you know what it really means?
One of the first people to coin the phrase “Time is money” was Benjamin Franklin in his book, “Advice to a Young Tradesman, Written by an Old One”.
The original quote was:
“Remember that Time is Money. He that can earn Ten Shillings a Day by his Labour, and goes abroad, or sits idle one half of that Day, tho’ he spends but Sixpence during his Diversion or Idleness, ought not to reckon That the only Expence; he has really spent or rather thrown away Five Shillings besides.” – Benjamin Franklin
The point good ‘ole Ben was trying to get across was that for each hour you don’t work, it’ll cost you money (unless of course you have assets bringing in passive income). 🙂
What Is The Time Value of Money?
The time value of money (TVM) is a useful concept that enables you to understand what money is worth in terms of, you guessed it, time.
This is expressed in a formula which basically states that money is worth more NOW than it will be in the future.
This is mainly due to inflation which increases prices over time and decreases your dollar’s spending power.
Many of the financial decisions we make now and in the future involve the importance of time value of money.
- taking out a 15 vs 30 year mortgage
- buying a car on credit (no thanks)
- investing in stocks, mutual funds or bonds
Here’s a handful of examples of how inflation increase the price on everyday items.
*All images are courtesy of AARP.
First class stamp
Back in the mid-80’s, you could mail a letter for 22 cents. That same letter today will cost you 55 cents to mail thanks to inflation.
Ticket to a movie
If you wanted to go see a movie back in 1985 such as Back To The Future or Rambo: First Blood Part 2, you’d have to shell out $3.55 per ticket. That same ticket today is right around $9.00.
If you throw in popcorn and coke then you may have to borrow money from your kids!
One of the most popular cars in the ’80s was the Honda Accord. Back then the base price was $8,845. Today one can be yours for $24,770.
It seems like kids grasp the concept of the time value of money better than adults. Don’t believe me? Try asking one if they’d rather have $100 now or pay them 10% interest and give them $110 a year later.
How many would wait? I’d guess close to zero. Heck, most adults wouldn’t either!
I think that many savvy investors are starting to grasp this concept and changing the way they invest. Instead of socking away money that will be locked up in a 401K for 30+ years, they are investing for cash flow that can replace their expenses now (accumulation model vs cash flow model).
Because they want options NOW and know that buying stuff is only going to become MORE expensive each year. They’d rather have that money now rather than later.
Why Is the Time Value of Money Important?
Remember that Inflation increases prices over time so every dollar in your pocket today will buy MORE in the present than it will in the future.
This makes investing even more important than most realize.
The TVM helps in that it allows you to make the best decision about how to handle your money based on:
- inflation – Inflation causes the cost of goods and services to continue to rise. You can buy more with $100 now than in twenty years. Money you have today has a higher purchasing power.
- risk – You understand that a lot can happen in the future. Due to unforeseen circumstances, you may not get all of your money, or any at all. But you can lower your risk to zero if you’re paid today.
- investment opportunity – There are a lot of ways you can make your money grow today (real estate investing). But if you wait ten years to receive your money, you’re losing the opportunity to invest.
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The Importance of Time Value of Money in Real Estate Investing
You didn’t think a real estate investing blog would leave out how the TVM could help them too now did you?
Real estate investors can use this concept to help determine what future cash flow from a real estate investment would be worth in today’s dollars.
It can also help to determine whether you’re better off using your cash now for something such as a rehab, or borrowing money and conserving cash for another purpose.
The Importance of Compounding Interest
Even though we now know that the TVM teaches us that money is worth MORE today than in the future so we should spend it now versus save it for later; we also know that sometimes that isn’t the case.
While inflation works against you, eating away at the value of your money, compound interest works for you to raise the value of your present dollar tomorrow.
What Is Compound Interest?
Compound interest is simply earning interest on interest.
In other words, it works by calculating the interest on your entire account balance which also includes the interest that’s been accrued.
Here’s a compound interest formula:
For example, if you have $1,000 and it earns 10% each year for five years, in the first year you’ve earned $100 in interest (10% of $1,000).
In year #2, things start to pick up as you’re actually earning interest on the total amount from the previous compounding period, which would be $1,100 (the original $1,000 plus the $110 in interest earned in year one).
By the end of year two, you’d have earned $1,210 ($1,100 plus $110 in interest). If you keep going until the end of year five, the original $1,000 turns into $1,610.
The Time Value of Money Formula
Now that we’ve learned what the importance of the time value of money is, how then do we go about measuring it?
We do so by using a specific formula which takes the present value, multiplies it by compound interest for each payment period and factors in the time period when the payments are made.
Formula: PV = FV / (1+I)^N
PV: present value
FV: future value
R: rate of growth or interest rate
N: number of periods (typically measured in years or months)
Using the Time Value of Money Formula
I get it. Who wants to use a complex formula? It’s essential if you want to answer questions such as:
How much would I need to save beginning today if I want to become a millionaire in 20 years, assuming a 7% growth after inflation?
You could also use this formula to calculate anticipated future costs like college, purchase of a home, weddings, etc.
If I start with with an account balance of zero today and put away $500 a month, what will I have in 10 years if I get a 6% growth after inflation?
This is a great way to see the direction you’re headed in.
Using this calculation with kids is a GREAT way to motivate them to focus on saving money at an early age.
Here’s an online calculator that you can use to speed up calculations.
Now you’ve come to realize the importance of the time value of money and that it tells us that money we have now doesn’t have the same value in the future.
By knowing this, we’re able to make we’re able to set goals and make choices that affect our financial life.Join the Passive Investors Circle