I have an interesting guest post for you today from Michael who blogs over at Stretch a Dime. “The Time Value of Money” is is an extract taken from his book “High School Money Hacks”. Hope you find it useful and please head on over to check out Michael’s book and blog after reading this post!
Understanding the time value of money is key to everything in finance. If you grasp this concept early on in your life, you will be able to assess every common real life financial question with clarity, decide objectively, and avoid a whole of lot of bad financial decisions. You will be light years ahead of your peers.
If you have $100 in your wallet now, then its present value is $100. Present value is referred to as PV.
You take the $100 you have now in your wallet and deposit it into a savings account in a bank. Let’s say that the bank gives you an annual interest of 5%. For simplicity, let’s assume that compounding is done annually. At the end of one year, your savings account will have:
• Total = Principal (this is the amount you deposited) + Interest.
• Principal = $100 (this is the amount you deposited).
• Interest = $100 * 0.05 = $5.00 (5% of $100, interest earned during the one year period).
• Total = $100 + $5 = $105.
In other words, the future value (FV) at the end of one year is $105.
Uncle Jake comes over and tells you that he will give you $100 today. Your friend promises to give you $100 a year from now. Are these two valued the same? If you answered yes, sorry, but that’s not correct.
Here’s why – you could deposit the $100 that Uncle Jake gave you today in a savings account. If the savings account gives you 5% interest, then a year from now what you received from Uncle Jake would be worth $105, right?
What your friend would give a year from now would be worth $100. So, you are comparing $105 to $100. Clearly, Uncle Jake giving you $100 today is greater in value than your friend giving you $100 a year from today. Also, bear in mind there is always the chance that something might happen and your friend might change his mind and not give you the $100 a year from now.
Important rule: When you make any financial comparison, it has to be based on the cash value at the same point in time.
The beauty of finance
In the above example, the comparison was done at a future point in time. We compared the future value (FV) at one year from now. We could also do the same comparison in today’s dollars using the present value (PV). Let’s explore how to do that.
What Uncle Jake is giving you today is $100. Therefore, PV = $100.
Your friend has promised to give you $100 a year from now. FV = $100.
What is the PV of what your friend is giving you a year from now assuming the interest rate is 5%?
• PV = FV / (1 + Interest Rate).
• PV = $100 / (1 + 0.05).
• PV = $95.23.
The $100 your friend is giving you one year later is valued at $95.23 in today’s dollars if you earn 5% interest on it.
The key takeaway: Uncle Jake is giving you $100 in today’s dollars (PV) and your friend is giving you $95.23 in today’s dollars (PV). Obviously, Uncle Jake is giving you more than your friend.
Here comes the real beauty of finance. You can travel the timeline in both directions (PV to FV, FV to PV), check your calculations, and audit your own work.
Why is there a time value of money?
A farmer borrows $100 from the bank at a 5% interest rate, compounded annually. He grows tomatoes and sells the harvest for $150. He pays back the bank $105 which includes the principal and interest. He keeps $45–that is his net profit.
There is time value for money because value is created (in this case, the produce – tomatoes) with the money over time through how it is used. Otherwise, everyone just needs to be borrowing and lending without doing anything else.
I would like to repeat – the most important takeaway is that “when you make any financial comparison, it has to be based on the cash value at the same point in time.”
If you understand the time value of money and apply it to your daily life, you will be very effective in your financial decisions.
Author Bio: K. Michael Srinivasan, author of personal finance blog Stretch A Dime, where he writes about personal finance, investing, and frugal living. He is the author of the book “High School Money Hacks”.