What Is The Time Value Of Money?

The time value of money means that money is worth more now than in the future because of its potential growth and earning power over time. In other words, receiving a dollar today is more valuable than receiving a dollar in the future.

Here’s more about the concept, how to calculate the time value of money and why it might be an important tool for financial decision-making.

What is the time value of money?

The time value of money is the idea that receiving a given amount of money today is more valuable than receiving the same amount in the future due to its potential earning capacity. In other words, just as a bird in the hand is worth two in the bush, a dollar in hand — and invested — today is worth more than a dollar received tomorrow.

• Investing: If you invest $100 today, that money can start earning interest, for example. In the future, your initial investment will be worth more than $100 due to the earnings on that investment. So receiving $100 today is more valuable than receiving the same amount in the future.
• Inflation: This applies to inflation, too, because the value of $100 buys fewer and fewer goods over time due to rising costs.

Understanding the time value of money can help you with personal finance, such as making decisions regarding your salary, loans and investments. For instance, if an investment offered you $15,000 today or $15,750 in three years, what would you do? While it might seem worth waiting for the higher payout, taking the money today is probably the better bet.

• Investing: You can invest it and potentially earn far more than $750, which is just 5 percent.
• Inflation: Your purchasing power is likely greater now than it will be in three years.

In short, the time value of money is the expected return — or cost — of that money over a given time period.

How is the time value of money calculated?

You can calculate the time value of money using the following formula. Bankrate has an online calculator that’ll do the math for you.

FV=PV(1+i/n)^n*t

Alternatively, you might see the formula inverted to calculate the net present value of future income:

PV=FV(1+i/n)^n*t

Key:

FV: Future value of money. More on that below.
PV: Present value of money, also explained further on.
i: Interest rate or the discount rate, which is a risk-free rate of return or an inflation rate.
n: Number of compounding periods of interest per year.
t: Number of years.

The formula comes in handy when you want to determine the future value of an investment. For example, say you have $10,000 and you want to invest the money for five years. To find the future value of the investment, you’d plug those numbers plus the interest rate and compounding periods into the formula.

FV=$10,000(1+3%/1)^12*5

So for a savings account with a 3 percent interest rate that compounds annually — that’s the second and third “1” in the formula above — you’d have $11,592.74 in five years.

What is the future value of money?

The future value of money is the amount of money you’ll have in the future, assuming you invest a specific amount in an account with a certain interest rate. Investors can use this calculation to compare different investments, such as a high-yield savings account versus stocks. The math can become tricky because it assumes growth will be stable. For accounts with a set interest rate and one upfront payment, the formula is simpler, as you can see from the above example.

When we get into compounded annual interest, the formula becomes more complicated because you have to account for the interest rate applying to the cumulative balance.

Some practical applications of the future value of money:

• Purchasing: Use the concept to help decide whether it’s better to put no money down on an item such as a car or to finance part of the purchase. For example, the future value in 10 years of $25,000 today, assuming 5 percent compounded annually, is $40,722. A $25,000 car suddenly looks a lot more expensive.
• Saving: The same concept applies to increasing retirement contributions as opposed to spending the money today. You can calculate how much you can expect to have in retirement and what the true cost of purchasing that new item is in terms of the money you’re giving up in the future.

What is the present value of money?

The same principle works in reverse, allowing you to convert the future value of money into the present-day value. For example, if you receive $500 in three years, that’s equivalent to receiving $431.92 today with 5 percent interest annually on it. So if you were given the choice to receive $431.92 today or $500 in three years, you might be ambivalent if you know you can earn 5 percent on your money over that period.

The expected return you might receive over time — what experts call the discount rate — has a big impact on the present value:

• A higher discount rate means the present value of a future sum of money is lower.
• A lower discount rate means the present value of a future sum is higher.

Using the $500 example, if you could earn 8 percent on your money over that three-year period, the present value of that money is $396.92.

Winners of the lottery might think about present value when they’re deciding whether to take a lump-sum payment today or payments over a longer period. If they can earn more interest than the discount rate lottery officials use to calculate the lump sum, it might be worthwhile to take the single payout, even if it’s lower, and invest it themselves.

What is the difference between present value and future value?

These two terms help you understand what your money is worth now versus later.

• Future value is the value of a sum of money, given a certain rate of growth, at a specific future date. For example, the amount you’ll have in five years after investing $1,000 in a savings account today.
• Present value is a similar concept but, instead, tells you how much you’d need in today’s dollars to yield a specific amount in the future, given a specific return.

These concepts are just different ways to view the time value of money.

How does the time value of money factor into decision-making?

The time value of money is useful for a number of financial decisions. Here are some of the most common ones you may come across:

• Evaluating whether it’s better to purchase or rent a home.
• Deciding how much to save for retirement.
• Deciding whether to pay off loans or invest.
• Deciding whether to purchase or lease a car or other equipment, including whether to pursue a cash discount or no money down payment.

For businesses, the time value of money can be used when a company is considering whether to invest in developing a new product, acquiring new business equipment or facilities or establishing credit terms for the sale of products or services.

For example, companies will use a formula to help determine whether to offer a 30-, 60- or 90-day credit term for the sale of products or services. The formula factors in the present value of money, the expected return on the investment and the amount of time.

How does inflation impact the time value of money?

Your purchasing power decreases with inflation, so a given amount of money today will not buy as much tomorrow. Think about it this way: If you set aside $100 for groceries and wait five years to spend it, you’ll come home with fewer bags than if you shopped immediately. Your future self will get less bang for the same bucks.

When you calculate projections for future returns, remember to factor in the rate of inflation to determine the real return on an investment. If the inflation rate is greater than the rate of return, the purchasing power of money will decrease.

Bottom line

There’s a reason the saying “time is money” is popular. Knowing the time value of money can help you weigh the costs and benefits of various investment and financial options. While it’s not the only factor in decision-making, it’s a valuable concept to keep in mind.

— Kim Husband contributed to an update of this article.