There’s a movie called “Every Second Counts”. It’s about a girl who wants to be a vet but her father doesn’t approve of it. Besides being an entertaining movie, its title couldn’t be any more accurate. Especially when talking about money, every second counts. The dollar you have on your wallet right now has more value than it will in an hour. ‘Why?’ you might ask. It’s called time value of money. Keep reading to find out more about it and learn how to use it to your advantage.
- Time value of money (TVM) refers to the amount of money that is worth more now than in the future.
- The formula for TVM helps you calculate what will be the value of a specific amount of money in the future.
- The earlier you receive the money, the more time it has to grow and earn interest.
- Investing is the best way to make money grow with the help of TVM.
- Many successful investors use TVM to make informed decisions about what to do with their money.
What is time value of money?
First of all, we need to understand what does time value of money means. TVM is a financial concept given to the amount of money that is worth more right now than the same sum will be in the future.
As simple as that. A 5-dollar bill is worth more now than the same 5-dollar bill will be tomorrow. It also applies to larger numbers. Let’s set an example which we’ll use further on.
Imagine you are a graphic designer and your best friend hires you to design a new logo for his company. You create an amazing logo with its different variations and your friend loves it. To pay you, he gives you the option of $1,000 right now or $1,000 within the next year. Taking into consideration the time value of money, you decide on the first option.
Maybe you are still wondering: Why would I choose the first option? What’s the difference? I still get the $1,000 over time, and I do my friend a favor by don’t rush him to make the payment.
To understand the logic behind this, we need to take a brief look at the numbers.
The Time Value of Money formula
The formula for the time value of money helps you to calculate what will be the value of a specific amount of money in a certain period of time in the future.
The formula for the time value of money has these variables:
- FV = Future value of money
- PV = Present value of money
- i = interest rate or other return that can be earned on the money
- t = number of years taken into consideration
- n = number of compounding periods of interest per year
With that in mind, the formula is:
FV = PV x [ 1 + (i / n) ] (n x t)
Let’s see it with the same example we used before about the logo you created. Let’s say you could use those $1,000 to earn 10% annually. The future value of your money would be:
FV = $1,000 x [ 1 + (10% / 1) ] (1 x 1)
FV = $1,100
If you put your money to work, your $1,000 would be worth $1,100 one year from now. In contrast, if you picked the second payment option, your friend would give you the $1,000 by the end of one year, taking away the chance to make that extra $100.
Next time you are facing this situation, be wise and do what’s best for your financial future.
Why would you choose the first option over the second?
As we could see from the previous example, the main reason why you should choose the $1,000 right now is that by having the money in your hands you can make good use of it.
For instance, just saving that money into your savings account can work as an advantage. It will earn interest and grow over time. Even better, if you keep that money saved and save the interest as well, it’ll be added to the principal amount, which let your money grow exponentially (grow even more!) thanks to the magic of compound interest.
What is important here is to put that money to earn interest as soon as possible. The more time it has to grow, the more interest you earn.
On the other hand, a much better option to make the most out of those $1,000 would be investing them. In fact, the best way money can grow is through investing. In our previous example, if you waited for your friend’s payments throughout the whole year, you’d lose the opportunity to invest that money as soon as you get it and make more than $1,000 in the same amount of time.
Keep in mind that the time value of money would be helpful as long as you put that money to work. It would be worthless to receive the $1,000 today and keep it all under your bed because you would not be taking advantage of the time value of money! Instead of hiding it, you could be using what you earned to generate more money and increase your wealth.
Many successful investors use the time value of money to make a more informed decision about what to do with their money. Investments are the best way of using TVM to your advantage, keep that thought always in mind.
The bottom line…
Time value of money is a real thing you can start using to your advantage. Maybe just saving money into your savings account and waiting for the compound interest, or maybe investing that money and making it work for you. There are a lot of options to start investing. You just need to find which one is the best for you depending on your financial situation.
Make sure to read the rest of our articles to learn more about the investment methods and how can they benefit you.