Understanding the time value of money

One of the most important concepts in finance is the time value of money. This is because so many of our financial decisions rely on the time value of money. For example, when you consider taking out a loan, the time value of money is one of the things that affects how much interest you will pay. If you want to save for retirement, the time value of money is also important because it affects how much money you will need to save.

What is time value of money?

The time value of money is based on the premise that money today is worth more than the same amount of money in the future. This is because money in the present can be invested in something and grow, while money in the future cannot because we still don’t have access to it. Time value of money is important because of its use in a variety of financial decisions, such as investment planning, retirement planning, and mortgage payments.

How is the time value of money related to opportunity cost?

The time value of money is also related to opportunity cost. Opportunity cost is the possible benefit that a person loses when choosing one option over the other. For example, if you buy a car, you may miss out on the opportunity to pay for a new condo’s down payment.

The time value of money is important because it can help you make decisions about how to best use your money. Should you invest it, save it, or spend it? By understanding the time value of money, you can make the most informed decision possible.

How do you compute the time value of money?

There are a few methods to compute for the time value of money, but the most common is the present value formula. This formula takes into account the interest rate and the number of periods (years) until you get your money back.

Formula for time value of money

You can calculate the future value of money by using this formula:

Present value x Interest rate x Time (a.k.a. Number of years in term) = Future Value

Since the interest is given annually, it is counted as 1 (once a year). If interest is given semi-annually, it becomes 2> Quarterly is 4, and monthly is 12.

To illustrate, here's an example:

Let’s say you invest PHP 100,000 (PV) for one year (n) at 10% interest compounded annually. The future value (FV) of that money is:

FV = PHP 100,000 x [1 + (10% / 1)] ^ (1 x 1) = PHP 110,000

You can also manipulate the formula to find the value of the future sum in present-day pesos. For instance, the present-day peso amount compounded annually at 7% interest that would be worth PHP 50,000 in one year is:

PV = PHP 50,000 / [1 + (7% / 1)] ^ (1 x 1) = PHP 46,730

What is the importance of time value of money in investing?

The time value of money is important in investing because it can help you in finding the right investment. For example, if you are interested in purchasing bonds, you need to examine the interest rates and their tenure. Although its interest rate is lower, a bond with 6.5% and a term of 7 years is a better investment than a bond with 8% and a term of 10 years if you are looking to use the money right away. This is because you get to use the earned interest sooner in the former bond option, allowing you to re-invest it and let it grow even more.

How else is time value of money used?

The time value of money can also be used to make decisions about retirement planning, mortgage payments, and insurance.

• Retirement planning
  The time value of money is important in retirement planning because it can help you decide how much money to save now in order to have the same amount of money when you retire. For instance, if you plan on building a retirement fund of PHP 5,000,000 in 20 years, you need to invest PHP 2,512,815.21 in a vehicle that earns 3.5% annually.

• Loan payments
  The time value of money is also important in making loan payments. This is because the sooner you pay off your loan, the less interest you will have to pay.

• Inflation
  The time value of money also affects our purchasing habits. The time value of money helps us understand how inflation affects the purchasing power of money. Inflation is when a unit of currency today can buy more goods and services than the same unit of currency in the future. This is because, as prices rise over time, the money you need to pay for the item or service must also go up. For instance, if in 2000, you only needed P100 to buy a large cup of coffee. But because of inflation, by 2010, you now need P150 to buy the same amount of coffee. This means that P100 no longer has the same purchasing power in 2010 as it did in 2000.

Understanding the time value of money can prove beneficial in getting the most out of your money. Maximize your money’s earning potential by investing it in the right vehicles. Start investing today so you can reach your financial goals. Head on to FirstMetroSec or Earnest to get started.