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The time value of money states that a dollar today is worth more than a dollar at some time in the future. Okay, it’s not that simple to understand at first glance so let me delve into this advice a little with some financial examples: If I invest $1,000 in a 5% savings account today, it will be worth $1,050 in one year. Therefore, if I can have $1,000 today or choose to have $1,000 one year from now, it is always better to have the money now. By saving and investing today, you make the time value of money work for you. Let’s look at the reverse of this, to see how the time value of money can work against you. Suppose instead of receiving $1,000 that you spent $1,000 by purchasing merchandise on your credit card. Remember that a dollar today is worth more than a dollar tomorrow, so in this case, you will have lost money because you will need to pay off your credit card account with money from the future (which is worth less than money today). In addition to having to pay with future money, you will also have to pay interest expense. So, in this case, if you paid off the credit card in one year (assuming 15% interest), you’d have to pay $1,150. You should think about the time value of money before making any decisions. Another, maybe even more important concept related to the time value of money is the compounding effect of money. The compounding effect of money is extremely important when making any financial decision. The compounding effect of money is often overlooked or underestimated by people when making decisions. When applied to all of your financial decisions, this effect is the KEY to long-term success! To illustrate the compounding effect of money, let me use some financial examples: Suppose you had invested $1,000 today in a 5% savings account. In one year, that account would be worth $1,050 [$1,000 + ($1,000 x 5%)], yielding a $50 gain. However, in year two, that same initial investment would be worth $1,102.50 [$1,000 + ($1,000 x 5%) + ($1,050 x 5%)], yielding a $52.50 gain. And in year three, the same $1,000 would be worth $1,157.63, yielding a $55.13 gain. By year ten, the initial $1,000 investment would be worth $1,629 and by year 25 it would be worth $3,386. From looking at this example, you can see that investing $1,000 today is much more valuable than investing $1,000 even a couple of years from now. To accumulate wealth, you MUST use the time value of money and the compounding effect of money to your advantage.
457 and could buy the car in cash after just 40 months (just over 3 years)! The opportunity cost of the first alternative versus the second alternative results in a net difference of $7. only take the risks that are appropriate to you! For example: You have the choice of investing in a savings account. a large cap stock fund and an aggressive mutual fund (mostly tech stocks). Typically. In the first case you paid the bank $5.340 and have earned $240 in interest. you can get ahead by almost $8.45 over the five-year period. Because the $20.457 in interest. the bank or lender that gave you the loan uses the time value of money to their advantage. where instead of making the $424. in your initial payments.94 car payment. you should probably sway toward the lower risk investments. and 2) your aversion to risk. if you have 40 years to retirement.45 because you spent the money before you had it.239 and have earned $1. But if you are close to retirement or can't afford to risk your investments. the higher your potential investment return. Now. In fact.000! If you want to build wealth you need to take risks.000 to purchase a car and your auto loan was at a 10% interest rate (for 5 years). your investments will be worth almost $18.000 car in cash! So let’s weigh the differences between the two scenarios above. 15% bonds and 15% money markets). a money market account. you are actually earning interest and compounding the benefit yourself. CDs and maybe even a bond fund. Regarding risk aversion. By month 40. highest yielding sectors (maybe 70% stocks. you must make this decision yourself. you invest that payment at the same rate as what your car loan was (granted it’s a little high for a savings rate.039 in interest. The higher level of risk that you take. but the two most important factors are 1) your realistic time horizon. Regarding time horizon. you actually pay $25. but not unreasonable for other investments).This second example shows how the compounding effect can work against you: Suppose you borrowed $20. the higher your return should be. .496.457 gain versus a $5. If you have trouble sleeping at night because you're investing in stocks. Your monthly payments would be $424. With that said. the majority of your investments should be allocated toward the low-risk investments such as savings accounts. you should invest your money in the highest risk. you will have enough money to purchase a $20.496 loss). By the third year. a bond fund.496. instead of paying the bank. the higher level of risk that you take. meaning that you’ve in essence paid $5. Each investment has a different level of risk and each investment makes sense for different people. a certificate of deposit (CD). The right investment for you depends on many things.94. money market accounts. After one year you will have saved $5. That means that by making a simple deferral decision (buying the car in 3 years versus today).496 to borrow the money and in the second case you earned $2. Now look at this scenario. After two years.953 (a $2. you will have saved $11. In this case. the interest alone will account for almost 40% of your monthly payments.000 loan continues to compound over the life of the loan.000 and you will have earned $2.
all things being equal.000 now OR B. Congratulations!!! You have won a cash prize! You have two payment options: A. However. So at the most basic level. you can do much more with the money if you have it now because over time you can earn more interest on your money. Receive $10. taking the money in the present is just plain instinctive.000 in three years Which option would you choose? What Is Time Value? If you're like most people.The major takeaway from this section is that it is important to take risks. you would choose to receive the $10. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us.000 now. three years is a long time to wait. . doesn't it? Actually. The more risk you take the more you can expect to earn and accumulate over the long-term. Receive $10. But why is this? A $100 bill has the same value as a $100 bill one year from now. it is better to have money now rather than later. the time value of money demonstrates that. After all. be conscious of yourself and your goals and do not take more risk than your time horizon or your own personality will allow. although the bill is the same.
you are poised to increase the future value of your money by investing and gaining interest over a period of time.000.000 = $10. For Option B.450 left in your investment account at the end of the first year is left untouched and you invested it at 4.000 x [(1 x 0.000 x (0.000.5%.000 x 0.450 Manipulation: $10.450 and multiply it again by 1.045) + $10.045) + $10.5% and then adding the interest gained to the principal amount: Future value of investment at end of first year: = ($10. you would take the $10. we have provided a timeline: If you are choosing Option A.000 plus any interest acquired over the three years. which of course is calculated by multiplying the principal amount of $10. on the other hand.045 + 1) = $10.000 today.000 (the principal amount) by dividing the entire original equation by $10. the future value of your investment at the end of the first year is $10. The future value for Option B.450.Back to our example: by receiving $10. how much would you have? To calculate this.045 +1).045) + 1] = $10. At the end of .450 The manipulated equation above is simply a removal of the like-variable $10. If the $10.000 = $10. compared to Option B? Let's take a look. and the payment received in three years would be your future value. Future Value Basics If you choose Option A and invest the total amount at a simple annual rate of 4. So how can you calculate exactly how much more Option A is worth.450 Final equation: $10.5% for another year.045 (0.450 You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation: • • • Original equation: ($10.000 by the interest rate of 4. your future value will be $10.000 x 0. you don't have time on your side. To illustrate. would only be $10.
then the third year. you would have $10. the present value would of course be $10. So.000 because present value is what your investment gives you now if you were to spend it today. If you know how many years you would like to hold a present amount of money in an investment. the future value of that amount is calculated by the following equation: Present Value Basics If you received $10.045).000 x (1+0. If $10.045) Think back to math class and the rule of exponents. then the second year.000 were to be received in a year.450 x (1+0. which states that the multiplication of like terms is equivalent to adding their exponents.045) = $10. Therefore.920: Future value of investment at end of second year: = $10. is equivalent to the following equation: Future Value = $10.two years. the equation for calculating the three-year future value of the investment would look like this: This calculation shows us that we don't need to calculate the future value after the first year. In the above equation.000 today. the present value of the amount would not be . and the exponent on each is equal to 1. then. the two like terms are (1+0. the equation can be represented as the following: We can see that the exponent is equal to the number of years for which the money is earning interest in an investment.045) x (1+0.25 The above calculation.920. and so on.
000 expected from a three-year investment earning 4. to find the present value of the future $10. If today we were at the two-year mark.000 payment expected in two years would be the following: Present value of $10. all you are doing is rearranging the future value equation above so that you may solve for P.000 as FV.000. we need to find out how much we would have to invest today in order to receive that $10. you must subtract the (hypothetical) accumulated interest from the $10. To find the present value of the $10. we can discount the future payment amount ($10.000 in the future. Remember. At an interest rate of 4.000 offered in Option B. In essence. In other words. you need to pretend that the $10.000 in two years.000 at end of year two: Note that if today we were at the one-year mark.000) by the interest rate for the period.38 would be considered the future value of our investment one year from now.000 to be received in three years is really the same as the future value of an investment. At the twoyear mark. we don't have to calculate the future value of the investment every year counting back from the $10. So.000. the $10. the above $9. we would discount the payment back one year.000 is the total future value of an amount that you invested today.5%. or the amount that we would have to invest today.000 investment at the third year.000 to be received in one year is represented as the following: Present value of future payment of $10.000 you will receive in the future.000 in one year: Of course.$10. in the present. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows: Let's walk backwards from the $10. at the end of the first year we would be expecting to receive the payment of $10. here is how you can calculate today's present value of the $10. the calculation for the present value of a $10. the present value of the $10. Continuing on. To achieve this. We could put the equation more concisely and use the $10. To calculate present value.5%: . because of the rule of exponents.569.000 because you do not have it in your hand now.
) Conclusion These calculations demonstrate that time literally is money .000 in four years.97 now and then investing it for three years. your choice gives you a future value that is $1.000 today and invest the entire amount. you may actually end up with an amount of cash in four years that is less than $18.000) greater than the future value of Option B.000 or $15.66 ($11.237. . If you choose to receive $15.000.48 today.000 .411.000 payment in four years would be calculated as the following: Present Value From the above calculation we now know our choice is between receiving $15.the value of the money you have now is not the same as it will be in the future and vice versa.762. Present Value of a Future Payment Let's add a little spice to our investment knowledge. So. You could find the future value of $15.762. all we are doing is discounting the future value of an investment.000 that you receive from Option A.66 .97) more in cash! Furthermore. In other words. choosing Option B is like taking $8.$8.000 if interest rates are currently 4%.03 ($10. Which would you choose? The decision is now more difficult. see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.000.762.97 today if interest rates are 4.000 today or $18. it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.So the present value of a future payment of $10. Remember that the equation for present value is the following: In the equation above. if you invest the $10. the present value of an $18. Of course we should choose to postpone payment for four years! (For related reading. Using the numbers above. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15.386. let's find the present value of $18.5% per year.000 is worth $8. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1.411.$10. but since we are always living in the present.
we have provided a timeline: .illustrate.
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