- Time Value of Money (TVM) is the concept that a dollar today is worth more than a dollar tomorrow.
- Understanding TVM allows you to assess financial risks and opportunities.
- The principle underlies almost every financial and investment decision you make.
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Time Value of Money (TVM) is the concept that the money you have in your pocket today is worth more than the same amount would be if you received it in the future because of the profit it made. can generate during the interim.
For example, let’s say you can receive a payment of $ 100,000 today or $ 10,000 per year for the next ten years for a total of $ 100,000. Ignoring taxes, today’s $ 100,000 payment is worth more, according to the TVM principle, because you can put your money to work. For example, you can invest in stocks, buy real estate, or put it in a certificate of deposit (CD).
Understanding the time value of money can help you make decisions such as which job offers the best salary, the right rate for a loan, or whether the investment you are considering has good growth potential.
How the time value of money works
The time value of money is an important concept to keep in mind because your money, once invested, can grow over time. Even if you were to just put it in a CD or savings account, the money can earn compound interest.
On the other hand, money that is not invested will lose value over time. Just think about what you could buy for $ 1 as a kid compared to what that same $ 1 would earn you today. This is because inflation and the loss of potential income are eroding the value of your dollars. If you keep your money under your mattress for 10 years, not only will it be worth less because of inflation, but you will also miss out on the interest it can earn when invested.
“So many young people are so busy juggling life that they miss out on compound returns by investing smaller amounts of money,” says Jeff Rose, founder of GoodFinancialCents.com. “Say, for example, a 25-year-old had to invest $ 50 a month today, he would have to invest 3-4 times as much to make up the difference if he procrastinated until 35 years old.”
TMV is a fundamental concept that forms the basis of virtually all financial and investment decisions. From taking out a loan to negotiating a salary or making a purchasing decision, use the time value of money to assess the best financial course of action.
How to calculate the time value of money
Now that you understand what the time value of money is, let’s look at a real life example. Let’s say someone wants to buy your car and they can offer you $ 15,000 today or $ 15,500 if they can pay you in two years. TVM tells us that $ 15,000 today is worth more than $ 15,500 in two years.
Here is the basic formula for calculating the future value of money:
- PV is the present value of money.
- I is the rate of interest or any other return that could be obtained.
- t is the number of years to consider.
- m is the number of compound interest periods per year.
This will help you determine how much money you will have if you took the $ 15,000 and invested it today or if you waited two years for the $ 15,500.
The financier to take with
The time value of money is an important concept for personal finance to understand. It can help you decide on the budget to spend, evaluate a job posting, determine if a loan is a good deal, and save for the future. TVM shows why your money loses value over time due to inflation.
Apply the TVM formula to all the loans you have to determine whether it is better to pay them back or invest. You can also use it to see how increasing your pension contributions can affect the future value of your dollars. It’s a great tool that gives you information that can help you make smarter financial decisions.