Time Value of Money: Understand and Use It to Make Good Financial Decisions
Which is worth more: $100 today or $100 a year from now? Does it depend on if you’re paying or receiving the $100? How you answer may be based on your understanding of the time value of money. Let’s explore this concept and figure out how we can use it to make better money decisions.
Understanding the Time Value of Money
Say you’re given the following situation as a choice. You can take a lump sum of money now or wait a year to collect it. Most people would prefer to get the money now, merely because they have needs that the money can fulfill immediately. They have bills to pay or have wants and needs that can be realized.
However, many people don’t know that accessing the money unlocks the time value of money. This says that the amount of money you have now is more valuable than the same amount in the future. $1 today is worth more than $1 tomorrow and $1 a year from now. The time value of money concept is useful for installment loans, like mortgages or car payments. It is also valuable for interest-bearing accounts, like an IRA.
Sometimes it’s hard to figure out what is better: taking the money now or waiting until later. You may need to determine the value of each option to guide you in making your decision.
The Time Value of Money Calculations
To calculate the time value of money, you need to know a few terms.
- Present value. This is the sum of money you have today.
- Future value. This is the sum of money you will have at some later time.
- Discount rate is the percentage rate that is used to determine the present value of the future amount. It can often be approximated at the interest rate.
When considering the discount rate, there are two main factors: risk and opportunity cost.
- The more risk you take on, the higher return you will expect. For example, if you put $100 in a bank, you may be willing to accept $5 return on investment after a year. This is because the risk that the bank will not repay you is low. However, if you lend the same $100 to a stranger, you may require $20 return on investment instead. The person is a stranger; you do not know if they will or will not repay you. To take that level of risk, you require them to pay you $20 extra for the use of your money.
- The opportunity cost is the cost of the benefit that is lost by choosing one option over the other(s). If you have the money available right now, you can invest it immediately, or you can apply it somewhere else. Let’s say you choose to apply it somewhere else. The opportunity cost is the value of the interest you could earn while the money is invested.
Given the present value of some money and the discount rate you can find the future amount using
Future Value = Present Value x (1+Discount Rate)
Let’s say you know how much you want to make, and you know the discount rate you’ll get. If you want to know how much money you’ll need for the initial investment, use
Present Value = Future Value ÷ (1+ Discount Rate)
(You can also use the calculator here to find the present value of cash flows.)
Let’s use an example to drive the point home. You have $1000 today that you can invest for a year at a 7% discount rate (the interest rate). The value of that $1000 one year from now is
Future Value = $1000 x (1 + 0.07) = $1000 x 1.07 = $1070.
To have $1000 today, you would have needed to invest some money a year ago. Your future value is now $1000, and you would use the same discount rate. At that time, your present value would have been
Present Value = $1000 ÷ 1.07 = $934.58.
What if you wanted to project the value of your money beyond a year? For the future value of your $1000 you use
Future Value = Present Value x (1 + Discount Rate)(number of time periods)
So the future value of your $1000 after 5 years, assuming a 7% discount rate per year, it would be
Future Value = $1000 x (1 + 0.07)5 = $1000 x 1.40255= $1,402.55.
Similarly, if you want to the initial investment needed to earn $1000 in 5 years, you can rearrange the formula. Assuming the same interest rate, your future value will be $1000 and your present value would be
Present Value = $1000 ÷ (1 +0.07)5 = $1000 ÷ 1.40255 = $712.99.
You would have had to invest $712.99 five years ago at a 7% interest rate to have $1000 today.
Real-Life Time Value of Money Scenarios
We can use the time value of money in everyday money decisions. Take, for example, the following situations:
- Congratulations! You’ve finally won the lottery! The lottery commission is giving you a choice of how you would like to be paid. You can either receive $1000 per week for life or an immediate lump sum settlement of $1.5 million. What would be the best option? There is no straightforward answer to this situation. Your answer would depend on a few factors that are specific to your life situation, such as:
- Your age, and your life expectancy. If your life expectancy is short, you may not get the full value of your winnings at $1000 per week.
- What current investment opportunities are available to you. Taking the lump sum but having nothing to invest it in may not be worthwhile.
- The stability of the organization making the payments. Will the lottery commission be around “for life”?
- You are receiving a payout which is worth $100 today. This same payout, if taken later, will be worth $110 then. When making your decision, consider the following:
- Where is the interest coming from?
- Where can you invest that $100 today and how much would it be a year from now?
- You’re going to get an extra $1,000 on your tax refund. There are many things you can do with that money, but you’ve narrowed it down to two choices. Should you invest the $1000 for the next 20 years or use it to pay down your mortgage today? When you make your decision, you should think about:
- Your current and future mortgage rates.
- The investment opportunities for this money.
Make Better Financial Decisions
Time value of money is a fundamental concept to understand when trying to decide between two or more financial options. Does it make sense to take the money now, or should we leave collect it at a later date? The answer depends on a number of factors specific to your personal situation. Regardless of what option you choose, knowledge of the time value of money helps you understand how much is at stake.