Explaining the Time Value of Money
Say you’ve won a small cash prize. You’re given two options: $50 now or $50 in one year. You’re going to take the $50 now, right? Why wait a year when you can have the exact same amount today? It’s instinct.
It’s also likely a smarter financial decision. A dollar today can be worth more than a dollar tomorrow (or in the case of our example, $50 today is worth more than $50 next year—we’ll discuss why that is below). That’s the essence of the Time Value of Money.
Why is $50 today worth more?
There are two main reasons:
- If you take the $50 now, you can put it in the bank and earn interest or invest it and trade risk for potential returns. By this time next year, while the difference might not be huge, your $50 could be more than $50.
- Inflation happens. Prices often increase over time, which in turn makes the dollar worth less. In 2017, inflation averaged 2.07%, for example, so your $3 coffee was theoretically $0.06 more expensive by the end of the year. That means your $50 could go farther today than it will in a year. Of course, inflation isn’t guaranteed either—in some cases, there may be a decrease in the general price of goods and services called deflation.
The time value of money in action
One very real example of the time value of money in action that affects many of us: saving for retirement.
You’re 30. You’re hoping to retire when you’re 60. You have $5,000 saved that you want to invest for the next 30 years for your retirement. For the sake of this example, let’s say you earn an annual return of 6%.
What happens to your money over those 30 years given the time value of money? If you earn 6% each year for 30 years, your $5,000 will be worth $28,717.46 (For you math nerds following along at home, we got to that number by using Future Value = Present Value x (1+ Rate)# of Years).
Not bad. But what if you also contributed an extra $1,000 to your savings every year? Your $5,000 and yearly $1,000 contributions earning 6% would be worth $107,775.64 by the time you turn 60.
Why this matters
Understanding the time value of money is key to understanding why investing should be part of a long-term strategy for many people. The sooner you start the better. When it comes to investing, time literally is money.