The time value of money, or TVM, is a fundamental concept that affects your financial planning and investment success. Whether you’re considering borrowing, saving, or investing, understanding TVM helps you make better money decisions. This post will review the time value of money, why it matters, and how to calculate your investment returns.
What is the time value of money (TVM)?
The time value of money is the concept that a dollar today is worth more than a dollar tomorrow. For instance, if you’re paid $1,000 now, it’s more valuable than getting paid $1,000 in a year. That’s because you can save the money in a bank and earn interest or invest it for potential growth during the year.
However, the value of money depends on factors such as inflation and the potential interest rate you could earn. Inflation reduces TVM because it increases the prices of goods and services, reducing the purchasing power of your money.
Interest increases TVM because it allows your money to grow. For example, if you earn 4% APY in a high-interest savings account, $1,000 would earn $40 annually. If the interest you get paid remains in the account, it also earns interest, known as compounding interest.
When your earnings continually get reinvested, your money grows faster and faster. The more time you have to allow the cycle of compounding to work, the more wealth you can build. That’s why the length of time you invest can be more important than the amount you invest. I’ll give you an example in a moment.
While you can never be sure what return an investment will provide unless it comes with a guarantee, TVM says a dollar today is worth more than a dollar promised to you in the future. All things being equal, it’s better to have a sum of money now rather than later.
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Example of the time value of money (TVM)
To understand the power of compounding and TVM, consider two investors, Adam and Teri.
Adam starts investing in a tax-advantaged 401(k) when he gets his first job at 21 and contributes $1,000 yearly. However, let’s say he only invests for ten years, for a total contribution of $10,000, and then stops. His money continues growing with an average 8% return from age 31 to 65 with no additional contributions. At age 65, Adam would have just over $230,000.
Teri is a similar investor but doesn’t start until 31. She also invests $1,000 a year for ten years in a traditional IRA and then lets it grow with an average 8% return until age 65. She would have just over $107,000 in the account–less than half of Adam’s balance. Having ten fewer years of compounding caused her to miss having an extra $123,000 for retirement.
Adam took advantage of the time value of money by putting it to work earlier than Teri and building more wealth with his $10,000. Teri builds less wealth by delaying investing even though she also contributed $10,000. So always remember that a delayed investment is a lost opportunity!
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Variables affecting the time value of money (TVM)
You can use a physical or online financial calculator to calculate investment returns, like an HP 12C or an option at Calculator.net. You’ll need to understand a few variables to input and get the right results.
One is the present value or PV, which is the value that a future sum of money or cash flow has right now. For example, the present value of the $1,040 you’ll earn one year from now with an interest rate of 4% is $1,000.
In other words, a present value discounts a future amount back to the present, using the average rate of return. You can also use PV on a financial calculator to input your savings. I’ll take you through an example in a moment.
Another variable you can input or solve for is future value or FV. It’s the value that a current sum of money will have at a future date based on an expected rate of return. For example, the future value of $1,000 one year from now, with a 4% growth rate, is $1,040.
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Why the time value of money (TVM) matters
When you fully understand the time value of money, it helps you make better decisions about how much and when to invest. It can also help you compare advanced investment opportunities involving future payments and cash flows.
Let’s say you want to retire with $2 million when you’re 65. Right now, you’re 30 and have $10,000 saved. You believe earning an average return of 7% over the next 35 years is reasonable. So, how much do you need to invest to reach your $2 million goal?
You can quickly get the answer by following these six steps on a financial calculator:
- Clear your calculator.
- Enter $2 million, then hit the FV button.
- Enter $10,000, then hit the PV button.
- Enter 35, then hit the n (number of years) button.
- Enter 7, then hit the i (annual interest rate) button.
- Hit the PMT (payment) button to solve.
The results show that you must invest just over $14,000 annually to grow your account from $10,000 to $2 million over 35 years. You can adjust your goal or timeline as needed to understand precisely how much you must invest and your future account balance if you stick to a plan.
Another situation you might want to solve is knowing when to stop investing. Let’s say you’re 50 and want to retire at 60 with $3 million. If you currently have $1.5 million in your retirement account, how do you know if you should keep contributing?
Here’s how to get the answer using a financial calculator:
- Clear your calculator.
- Enter $1.5 million, then hit the PV button.
- Enter 10, then hit the n (number of years) button.
- Enter 7, then hit the i (annual interest rate) button.
- Enter 0, then hit the PMT (payment) button.
- Hit the FV button to solve.
These inputs assume you won’t contribute to your retirement account and will earn an average return of 7% for ten years until you’re 60. The calculation shows that you’d have just over $3 million at that time. Therefore, you don’t need to invest more to reach your retirement goal.
To sum up, you can use five basic variables, present value, future value, interest rate, time, and payments, to understand an investment or set your retirement goals.