*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.

### Present Value

If you have $100 in your wallet now, then its present value is $100. Present value is referred to as PV.

### Future Value

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.

### A quiz

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.

### Conclusion

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”.

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Michael says

Thank you Hayley for the opportunity to guest post on Disease Called Debt!

Hayley says

No worries Michael, thank you for this post. I’ve found it useful!

Latoya @ Life and a Budget says

This is a very good concept that high schoolers should learn before graduating. Unfortunately, many of them dont. I will have to check out more of your work, Michael. Financial literacy is very important and this topic certainly has it’s use. Thanks for sharing your thoughts in an easy to understand matter.

Michael says

Hi Latoya,

Thank you! I wish I had known what I know now when I was 19 – I would have loved to have a copy of this book. I would have avoided a lost of costly mistakes.

Yes, financial literacy is very important at high school which is when you make some very important financial decisions like loans for college education. If it is not done wisely, the student loan could take the person down financially for a very long period of time – which is what is happening in America now.

–Michael

Michael recently posted…Should I have A Separate 529 for each child?

Eliane says

I think I can be happy that I learnt that already in school where they also used interest rates of 4 or 5%. The only problem is that interest today are between nothing and 0.01% where I live. So no use to put money in the bank.

Michael says

Hi Elaine,

Thank you for your comment. I used the interest rate as an example to illustrate the time value of money.

For example, S&P 500 has provided an average return of about 8% over a 50 year period. You could use that as a rule of thumb (benchmark) to compare and see if you are making good investment choices.

Time value of money helps you effectively evaluate every single financial decision you make.

–Michael

Michael recently posted…Should I have A Separate 529 for each child?

Jayson @ Monster Piggy Bank says

Good explanation Michael. It makes clear now that the value of money changes. We have consider this as well in investment that the money you put in is dependent on time.

Jayson @ Monster Piggy Bank recently posted…Five Factors to Consider Before Investing in Rental Property

Michael says

Thank you, Jason! Yes, we need to consider time value of money in every money decision we make – whether we are spending or investing.

–Michael

Michelle @ Lively Chicken says

Great post! This is not something I think about often, but it is so important. Thanks for sharing clear examples that are so easy to follow. Looking forward to reading some more of Michael’s work!

Michael says

Hi Michelle,

Thank you very much for your appreciation! I am so glad to hear that you enjoyed reading the post.

–Michael

Mrs. CTC says

Very valuable information, explained in a simple way. Good job Michael!

This is essential, I wish I realised this when I was very young. I will make sure my children understand it at a younger age (and then I’ll open the gates to the magic also referred to as ‘ compound interest’).

Mrs. CTC recently posted…So how is the debt doing? (We’re baring the numbers!)

Michael says

Hi Mrs. CTC,

Yes, me too, I wish I knew this when I was much younger. It is a great thing that you are planning to teach your kids. They will be light years ahead of their peer group.

–Michael

Michael recently posted…Should I have A Separate 529 for each child?

Bill @ The Money Professors says

Great article! As a personal finance professor I was frustrated by the number of textbooks that simply treated time value of money as an appendix or a small topic (that’s one of the many reasons I had to create my own!). It is the fundamental topic of the math behind personal finance! How can you determine how much to invest each month to reach your goal or if the car dealer actually gave you the rate that was promised if you cannot understand time value of money? When it comes to money knowledge really is power.

Bill @ The Money Professors recently posted…Why I Only Take All-Inclusive Vacations

Michael says

Hi Bill,

Thank you for your appreciation! I couldn’t agree more with you. TVM is the cornerstone for finance. Every decision hinges on it. If one does not understand TVM, he/she cannot make effective money decisions, that is the sad truth.

–Michael

Miss Thrifty says

Interesting post! I never thought of it in these terms before.

Is it bad that when you asked if the uncle’s money now and the friend’s money in a year were the same thing, I immediately said yes? I’d be excited about getting $100 or even $95.23! This really illustrates how money can sometimes blind us to logic and truth.

Michael says

Hello Miss Thrifty,

I am glad you learned the basics of the time value of money.

When it comes to money, you need to look at things very objectively without letting emotions come into the picture.

It is a virtue to be acquired. Over the years, it has become my second nature.

–Michael

Michael recently posted…Personal Finance Checklist

Ruth Curcuru says

Not quite as simple as you make it out to be. First, you’ll pay taxes on that interest that you earn, so, depending on the investment, you may or may not come out ahead after taxes. Secondly, the purchasing power of that dollar may fall as well. I’m not saying saving money/investing isn’t a good idea, only that there are a lot of considerations.

Michael says

Hi Ruth,

I am afraid you may be missing the point. It is an apple to apple comparison of money now vs. money later. This is the foundation of finance.

When you compare any money you receive or payout, it needs to be done at the same point in time. That is the whole point of the post.

$100 that you receive today is not the same as the $100 you receive a year from now.

If you want to use your own logic, the purchasing power of $100 in your hands today is $100. If the inflation is 3%, then you will only be able to buy $97 worth of goods with the $100 you receive a year from now.

–Michael

Michael recently posted…Personal Finance Checklist

Mel @ brokeGIRLrich says

Forget about high schoolers! I don’t think I’ve ever really thought of money that way. I’m always fine with waiting a little while longer to get paid back or to be the one who puts everything on my card and then waits for everyone to pay me. I suppose I never really thought about all the interest I’m missing out on – especially since so much of what I make does go directly into things that make interest, once my credit card is paid off.

Michael says

Hi Mel,

Thank you for your comment. Many adults don’t have a clue about TVM and it is so essential to understand it to be fiscally effective and responsible in life. That is why I emphasize that time Value of Money must be part of the curriculum for high school.

TVM works for you if you understand it and apply it in your day to day money decisions or against you obviously if you don’t understand it.

–Michael

Michael recently posted…Should I have A Separate 529 for each child?