The time value of money (TVM) is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. This is true because money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future. (Also, with future money, there is the additional risk that the money may never actually be received, for one reason or another). The time value of money is sometimes referred to as the net present value (NPV) of money.
How the Time Value of
Money Works
A simple example can be used to show the time value of money.
Assume that someone offers to pay you one of two ways for some work you are doing for them: They will either pay you $1,000 now or $1,100 one year from now.
Which pay option should you take? It depends on what kind of investment return you can earn on the money at the present time.
Since $1,100 is 110% of $1,000, then if you believe you can make more than a 10% return on the money by investing it over the next year, you should opt to take the $1,000 now.
On the other hand, if you don’t think you could earn more than 9% in the next year by investing the money, then you should take the future payment of $1,100 – as long as you trust the person to pay you then.
You can calculate the time value of money using the following formula. Or, there are several online calculators that’ll do the math for you.
FV=PV(1+i/n)n*t
Alternatively, you might see the formula inverted to calculate the net present value of future income:
PV=FV(1+i/n)n*t
Key:
FV: Future value of money. More on that below.
PV: Present value of money, also explained further on.
i: Interest rate or the discount rate, which is a risk-free rate of return or an inflation rate.
n: Number of compounding periods of interest per year.
t: Number of years.
The formula comes in handy when you want to determine the future value of an investment. For example, say you have $10,000 and you want to invest the money for five years. To find the future value of the investment, you’d plug those numbers plus the interest rate and compounding periods into the formula.
FV=$10,000(1+3%/1)12*5
So for a savings account with a 3 percent interest rate that compounds annually (that’s the “1” in the formula above), you’d have $11,592.74 in five years.
The future value of money is the amount of money you’ll have in the future, assuming you invest a specific amount of money in an account with a certain interest rate. Investors can use this calculation to compare different investments, such as a high-yield savings account versus stocks. The math can become tricky because it’s based on the assumption of stable growth. For accounts with a set interest rate and one, up-front payment, the formula is simpler, as you can see from the above example.
