Have you ever heard the term, a bird at hand is worth two in the bush? Today we are talking about money instead of birds. Although you can also sell the bird for money– I digress.Time value of money is a very important concept in finance.
My aim for writing this article is to refresh the concept of time value of money. After reading this article, you will
- Know the definition and importance of the time value of money
- Know the formula for calculating present value and future value of money
- Solve a life question using the formula mentioned above
- Get some insight into some of my quirks
What is the time value of money definition?
The time value of money is a financial concept that basically says money at hand today is worth more than the same amount of money in the future. Simply put, $1 today is far more valuable than $1 in the future.
This is due to the potential the current money has to earn more money. This is an important concept to understand in finance.
Suffice to say, the amount of money that you make is not the only thing that matters. It matters if the money is received today or in the future.
The time value of money can work for you or against you.For example, if you are deciding between buying a new phone for 1000 dollars, or invest in a stock for example that yields 10% per year. If you buy the phone, you have just incurred an opportunity cost of 10%.
Importance of time value of money
No matter how you slice it, every financial decision you make have an impact on your quality of life and the ability to enjoy the things you love.
Because of this, one of the most fundamental and cornerstone concept in modern finance to help us make those decisions is the concept of time value of money.
This concept is so important that it is equally applicable and useful in your personal finance and your business.
As an investor, this concept must be clear as day. Time is money and the sooner you earn or save that money, the faster you can put it to work for you
Time is money and the sooner you earn or save that money, the faster you can put it to work for you. Click To Tweet
Check out our post on the bizarre truth about the rule of 72 which further reinforce this concept. We even do the calculations for you and showed how the rule was derived (hint: The rule of 72 is really the rule of 69).
Try our compound interest calculator to determine how fast your money will grow at a certain interest rate. You will know exactly when your money will double.
Time value of money Video with examples
Time value of money example
First aid question: To answer the question in the headline, more information is needed.
What if the question is posed this way: Do you want 100,000 dollars now or 1,000,000 dollars in 30 years? Which one will you take?
What about 109,000 bucks next year instead? 300,000 dollars in 10 years? Ok, you get the idea.
Still, we need more information.
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Some assumptions
- The 100,000 dollars accrue 10% interest yearly.
- The interest is guaranteed. No bull or bear market
- This is an iron-clad contract. Remember those horror movies with contracts?
- The person offering the money can’t back out of the contract and you can’t change your mind either.
I know those who believe in the adage that says a bird at hand is better than two in the bush will quickly grab the 100,000 dollars now and run.
If you are preoccupied with the total sum of the money involved, you might jump at the 1 million bucks. But which one is the best choice?
Bear with me for a moment and let me use this to explain the concept of the time value of money.
If it helps you concentrate better, since mathematics is my forte, I will try to explain using the simplest mathematical formula.
The formula for future value of money
FV = PV X (1 + r) ^n
FV = Future value
PV = Present value
R = rate of return
N = the time period the money is invested.
We also assume the money will be invested.
Why 100,000 dollars: I love $100,000 because it is a round number and it is the right amount of money that will make a difference in most people’s lives. It will definitely make a difference in mine.
The answer to the time value of money example:
To solve the problem presented in the beginning, we need to calculate how much the 100k turned into a 10% interest rate in 1 year, 10 years and 30 years.
Summoning the equation gods
FV = PV X (1 + r) ^n
1 year
FV = 100,000 x (1+10/100)^1 = 100,000 x (1.10) = 110,000
10 years
FV = 100,000 x (1+0.10)^10 = 100,000 x 2.59 = 259,000
30 years
FV = 100,000 x (1+0.10)^30 = 100,000 x 1.75 = 1,750,000
Here is a calculator to play around with the numbers
Verdict
- I will take the 100k now vs 109 k next year
- I will take 300 k in 10 years vs 100 know
- 100k now, please! vs 1 million in 30 years.
Of note, we can also do this calculation backward too to find the past value of money.
Things I do to practice the time value of money concept
- Prioritize investing in a retirement account while in fellowship instead of paying off my 2.8% student loan (thank you Canada).
- I calculate my tax so that I owe or get a refund less than or equal to 1000 buck. This way, I am not giving the IRS an interest-free loan and thereby wasting my time value of money.
- Being a minimalist and worked extra shifts to pay off my student loan even while I was in fellowship and residency instead of spending like a villain.
- Pay my bills on the last day or few days before it is due. I figured if I pay in immediately, I am losing a month of compound interest. I set everything as autopay so I won’t forget. Yes I know it is a bit much but I do it. The amount might seem nominal for gas and electricity bills to some people, still makes me feel better.
In summary, it is better to invest now rather than later. Invest early to enjoy a long term compound interest.
Hustle early and live below your means to have enough cash flow to pay debt and invest.
Remember that the time value of money can work for you or against you, it is your choice.
If you want to start investing early, here is an article on the ultra easy beginners guide to investing.
Please let me know what you think in the comment. Pin our images.
Do you have things you do to reinforce this concept even if it sounds trivial to others?
Adebayo
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I am a pulmonary and critical care doctor by day and personal finance blogger/debt slaying ninja by night.
After paying off close to $300,000 in student loan debt in less than 6 months into my real job, I started on a mission to help others achieve the same. There is no magic to this than to strap up and get it done. Some of the ways we achieved this include side hustle, budgeting, great negotiation skills, and geographical arbitrage.
When I was growing up, common knowledge in Nigeria is that there is one thing you cannot trust anyone else with, and you guessed it – your money.
Being frugal came easily to me based on my background. However, the concept of building wealth did not solidify in my mind until when I finished medical school. I wish I knew what I know now when I was 14. Still, I don’t know enough and I am constantly learning to improve my knowledge.
My goal is to reduce financial illiteracy among young professionals. I am catering to the beginners – babies and toddlers in financial literacy.
