The most crucial part of your financial journey is understanding that reaching your financial goal takes time and requires periodic investing, where the magic happens. This brings us to the concept of the time value of money, a significant tool to add to your financial toolkit. It can help you stay motivated by seeing the estimated value of your savings in a few years.

Time Value of Money

The time value of money is the concept that a sum of money today is worth more than the same amount in the future, due to the potential earning capacity of that money if invested. This reflects the opportunity cost of not using the money to generate returns over time. For example, if you were to receive money owed by a friend now or in three years, which would you prefer? Now, because the alternative uses of that money are more valuable today than in the future, due to inflation and the loss of potential interest. However, saving and investing money can significantly boost your finances over time by applying the concept of the time value of money. This allows you to estimate the interest accrued through compound interest—interest on interest—which can greatly enhance your returns and may surprise you with how much your money grows by staying invested consistently.

Estimate Your Savings Worth (Future Value)

As you continue saving for the future, you may want to know when you’ll have enough money to make a substantial purchase, like a home or car. To evaluate this, you’ll need to consider:

• the amount to save (the principal)
• the interest rate offered by your bank, and
• the number of year(s) you intend to make the purchase.

While the impact seems small in the short term, the power of compounding grows over time, and a higher interest rate can help you reach your goal faster. Remember to stay invested to benefit from interest on interest as your savings grow.

Scenario I: Example of Compound interest

Suppose you have $5,000 in your savings account, saving up for a car, earning 6.25% annually:

Interest by the end of the year = Principal X Interest rate = $5,000 x 6.25% = $312.5 plus your principal which comes to $5,312.5

Assuming the cost of purchasing a car increases, you wish to keep your money for an additional year at the same interest rate of 6.25%

The interest rate at the end of the second year = $5,312.5 x 6.25% = $332.03

As you can see, the interest rate for the second year increases due to the compounding effect becoming more pronounced. This means that the longer you invest, the more your money grows.

Scenario II: Example of Future Value Interest Factor

This second example illustrates the significant impact of long-term saving, like over 20 years or more. This process involves using a future value interest factor (FVIF). You multiply it by your current savings, known as the present value. This helps decide how much your investment will accumulate.

Imagine you win an SUV in the McDonald’s Monopoly game. You decide to use your car savings of $5,332.03 to fund your newborn’s college tuition, investing it at an annual rate of 10.25% for 20 years.

Future Value (FV) = Present Value (PV) X FVIF

=$5,332.03 x (1+0.1025)²⁰ = $37,537.43

The result shows that significant increases in the present amount, interest, and the length of time you save, all proportionally boost your long-term growth

Estimate How Much to Invest (Present Value)

Estimating how much money you need to invest today to reach a specified amount in the future, while accounting for the time value of money, is known as Present Value or discounting. To calculate the present value of a given future amount, you need to know the future value, the interest rate earned on deposits, and the number of years.

For instance, if you are aiming to raise funds to own a popular pizza franchise, you need to accumulate $30,000. This amount is required for the initial fee. You need to gather this amount in 5 years at a steady rate of 6.50%. How much do you need today?

To calculate, using the Present Value Interest Factor (PVIF) multiplied by the specified future value (FV) amount

PV = PV X 1/ (1 + k)ⁿ     Where: FV = $30,000; k = 0.065; and n = 5

PV = $30,000 X 1 / (1 + 0.065)⁵ = $21,896

You need to invest $21,896 today at the stated rate to afford an initial franchise fee for your pizza business.  

The time value of money emphasizes that the present value of money is significantly higher than its future value. Prioritizing long-term investments is essential for your financial success.

Source
Kimmel, P. D., Weygandt, J. J., Kieso, D. E., Trenholm, B., Irvine, W., Burnley, C. D., Booth, L., Cleary, W. S., Kohser, R. A., & Aly, I. M. (2020). Financial Management (2nd ed.). John Wiley and Sons Inc.
Madura, J. (2020). Personal Finance (Seventh Edith). Pearson Education Inc.

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