When it comes to investing your money, do you know why you earn interest? The simple answer is because of the time value of money. See, a dollar today is worth more than one dollar tomorrow. The payment of interest compensates the saver for investing their money.
In this post, we are going to take a deeper look at the time value of money and see why it is critical that you need to understand it.
What Is The Time Value Of Money
The time value of money is a basic financial concept that says a dollar you have today is worth more than the same amount in the future because of the potential to grow the money.
For example, if I have the choice between having one dollar today or one dollar 5 years from now, I would choose the one dollar today. The reason is because I can put that dollar into a savings account and have it grow.
In 5 years, when I could have had a dollar, I instead have more than one dollar, thanks to interest.
In other words, you want to receive money as soon as possible so that you can save or invest it and have it grow into larger sums of money.
How To Calculate The Time Value Of Money
There is a formula to calculate the time value of money in your personal finance spreadsheet. In most cases, the below formula is the one you would use. However, there are slight differences to the formula if you have annuity or perpetuity payments. But for the sake of this article, we won’t get into that here.
Here is the formula to calculate the time value of money:
FV = PV x [ 1 + (i / n) ] (n x t)
Here are the values for the above:
- FV = future value of money
- PV = present value of money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
By simply plugging in your numbers and doing the math, you will see what the future value of any amount of money you have today will be worth.
So, if you are ever in the ideal situation of a stranger coming up to you and asking if you want $10,000 in one year or today, you can do the math and figure out the right decision.
Why You Need To Understand The Time Value Of Money
So what is the critical reason you need to understand the time value of money concept? It all comes back to growing your wealth. The sooner you can start saving and investing your money, the more money you will have in the future.
Too many people put off saving until a later date thinking it isn’t a big deal to wait. But it is a huge deal. Remember that any dollar you have today is worth more than any dollar you have in the future. All you have to do is take the step and start investing or saving that dollar.
When you do this, you guarantee that any dollar you have today will be worth more than one dollar in the future.
The time value of money is a critical concept you need to understand. Never forget that money today is more valuable to you than money tomorrow for the simple fact that you can earn interest on your money today and have it grow into larger sums in the future.
As a result of knowing this, take the next step and start saving and investing your money so that you do have more money in the future. Doing so will open many doors for you and give you options that you otherwise wouldn’t have if you spent all of your money.