I'm not going to kid you - this entry is BASIC retirement planning 101. If you have any investing experience at all, I'll admit right now, this is probably below you. Having said that, if you've never heard the words "Time Value of Money" (TVM) before, take a few minutes and read on. You'll gain some core investing and planning knowledge before you're done here.
You've heard of "Earning a Rate of Return" on your money, right? Of course you have...it's the basis for all interest and investment calculations. What you're really calculating out when we get into interest rates and returns is the "Time Value of Money". The TVM is a great tool in helping you understand the worth of money in relation to time. Financial professionals, investors, and pretty much anyone who has money sitting in accounts can use it to figure out the impact that time has on their dollars. It's also a foundation of retirement income planning - Have you ever wanted to map out what you'll need to sustain your lifestyle in retirement? If so, you'll have to use time value of money to find the answer (or just ask a financial advisor and we'll do it for you)! Let's go over the ins and outs of TVM.
What Is the Time Value of Money?
The idea behind the time value of money is that a dollar is worth more in the present than it is in the future, because money you have now has the potential to grow. This is largely due to inflation and erosion of spending power. If you think about it, $1,000 in 1999 could buy you more than it can right now, 20 years later, in 2019. In the same token, having a $1,000 today will theoretically buy you more than having $1,000 five years from now. With that in mind, the TVM formula can help you determine the present value (PV) of the money you have today and how much it could be worth in the future (FV).
Keep in mind with investing, however, there is a certain amount of risk you should consider as you start to learn and apply the time value of money. For example, if you're gung ho to take that $1,000 and invest it in your favorite company that’s expected to provide a 5% return each year, keep in mind that the 5% return is not guaranteed. Instead, with this any investment, you’re accepting the risk of losing money for the chance to beat inflation and increase the future value of your money. I'll be the first to tell you that there is a lot of market research to be done out there, as well as ENDLESS investment choices. It can be overwhelming and confusing, but this little education can go a long way in helping you feel better about your investing.
Why Is the Time Value of Money Important?
The TVM is important because it allows us to make more informed decisions about what to do with our money. It can help you weigh the pros and cons and understand which option may be best based on interest, inflation, risk and return. It can also be used to blueprint out your goals, which is a big deal. For example, if you have a certain goal in mind, such as saving $20,000 in five years if the account earns 3 percent compound interest each year, the TVM will help you figure out how much per month you need to be putting away to make that happen. The same goes for retirement planning! If you know you want to retire at age 65 and you and your spouse want to enjoy a $75,000/yr lifestyle in TODAY's dollars, the time value of money will show you the way if you apply it correctly.
The Importance of Compounding Interest
If the basic idea of the TVM is that money is worth more today than it is tomorrow, you’d think it’d be wiser to spend it now rather than save it for later, because now you're theoretically getting more value out of each dollar - but we know that isn’t always the case. While inflation does work against you, meaning it makes your dollar worth less tomorrow than today, compound interest can work in your favor to increase the value of your present dollar tomorrow. We often refer to this as "Earning a Rate of Return" or "Return on Investment" (ROI).
With compounding interest, the amount of money you’re earning interest on grows in each compounding period. For example, you start with $1,000 and it earns 10% compounding interest every year for five years, the compounding period would be one year. While that means in the first you’ve earned $100 in interest (10% of $1,000), in that second year 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 that going until the end of year five, you would have turned that $1,000 into approximately $1,610. This is what I like to call "Interest on Top of Interest" but most of the time it is not guaranteed. There is a certain amount of risk an investor must take to make this happen, with some special exceptions. If we consider that the highest inflation rate over the last 10 years was three percent, then in this scenario, choosing to invest your present money using compounding interest leaves you with a favorable and profitable outcome when compared to not investing it at all.1
The Time Value of Money Formula
The following make up the components of the TVM:
PV: present value
FV: future value
R: rate of growth or interest rate
N: number of periods (typically measured in years or months)
Using those values, this is the time value of money formula:
FV = PV x (1+I)^N
Or, if you’d like to understand the present value of future earnings, you could use:
PV = FV / (1+I)^N
Ok, that's probably a bit too much for a casual blog post, but you get the idea.To recap, these formulas can be used in different circumstances to help investors or savers understand the value of money today in relation to its earning potential in the future. The time value of money is an important piece of understanding the effect inflation has on our money and why investing early can help increase the value of your dollar by giving it time to grow and beat inflation rates.
If you have further questions about the Time Value of Money (TVM) or if you need some personalized attention, Click Here to schedule your free consultation!
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About the author: Kyle A. Davis is a Chartered Financial Consultant® , Chartered Advisor in Philanthropy® , and president of Integrity Financial Group in Orlando, FL. He is a Florida native and an advocate for financial literacy and practical money education. When not assisting clients in planning for retirement, he creates educational videos on financial wellness on his YouTube Channel - https://www.youtube.com/user/financialplannerinfl
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.