Time Value of Money (TVM)

If given the option, you would likely prefer to hold $500 in your hand today rather than two years from now, but what makes today’s dollars more valuable? Time value of money is the underlying concept that shows the difference between present value and future value.

Consider this:

Your employer or client gives you an option for your income. You can either receive $12,000 now, or $1,200 monthly for the next 10 months. By understanding the time value of money, you can weigh the opportunity for growth against the consistency of recurring payments.

If you forego the opportunity to collect and invest the money, you could lose earnings, or the client could suddenly disappear after paying only four installments. Because of the uncertainty of the future — in addition to the interest-earning potential and inflation — current dollars are worth more than future dollars.

Time value of money is important because it helps investors and people saving for retirement determine how to get the most out of their dollars. This concept is fundamental to financial literacy and applies to your savings, investments and purchasing power.

Time value of money can mean the difference between retiring comfortably or retiring with anxiety because you did not set aside enough retirement savings. Social Security payments alone may not completely cover your living expenses, so it is important to have other sources of income.

Time is the valuable factor here. The earlier you learn this concept and apply it to your financial planning, the better off you —and your savings — will be in retirement.

Funds that you invest today can grow, and that growth can compound over time.

For example, if you deposit $1,000 into a high-yield savings account with a 2 percent annual interest rate, you will have $1,020 in your account next year. The following year, you earn 2 percent on the $1,020 balance: an additional $20.40. Over time, the earnings can continue to build.

However, if you earned that initial $1,000 one year later, you lost the chance to earn $20 — or one year of 2 percent interest. You would miss out on the original $1,000 and potential earnings, which is the opportunity cost of waiting.

When evaluating investments, it is important to consider risk and reward because some investments come with higher risks and experience greater volatility.

Marguerita Cheng, Certified Financial Planner™ professional and chief executive officer at Blue Ocean Global Wealth, told Annuity.org, “Investments can fluctuate in value, especially in the short term, but they can appreciate at a rate greater than inflation — which is important in the long term.”

Inflation is the loss of purchasing power over time, so purchasing power often decreases as time progresses.

For instance, if a milk gallon had been priced at $2.50 in the 1990s and you needed $50 worth of milk, you could have bought 20 gallons.

Fast forward 30 years later, and you still wish to buy $50 worth of milk — but inflation has caused the price per gallon to increase to $3.50. Now, you can only purchase 14 gallons.

In simpler terms, your money can buy you more today compared with 30 years from now.

If you could receive an $800 payment now or $840 one year from now, which is the better option?

You can apply the time value of money formula to show the earning potential of money in its present value. It incorporates the following variables:

$800 = $840/(1+r)

The interest rate would need to be 5 percent for $800 to earn $40 in one year.

In this case, the original $800 can grow to $1,021.03 within five years.

However, some investing options have more compounding periods than others.

“If you have an investment with the same term and same interest rate, but more compounding periods, that will be more valuable to you because your money can work harder,” said Cheng, who is a retirement income certified professional.

Consider a certificate of deposit with quarterly compounding at 5 percent. To find the future value of money with the potential for multiple compounding periods, you can use this calculation:

FV = 800 x [1 + (.05 interest rate / 4 periods)] ^ (4 periods x 5 years or term)

Within five years, you would have $1,025.63, or $4.60 more because of the quarterly compounding periods.

Depending on your risk tolerance and investment options, time value of money can help guide your financial decision-making.