Do You Understand The Time Value of Money?
The phrase “time is money” is not just used in terms of a powerful career person talking to his or her subordinates. “Time is Money” is actually a mathematically proven statement that explains the value of money now versus its value in the future. The reason is simple: A dollar that you receive today can be invested so that you can have more than a dollar at some point in the future. Therefore $1 today, is worth more than $1 received tomorrow.
Perhaps you’ve heard the famous lottery debate: would you take the $100,000 now or in 5 years? Let’s just keep it VERY simple for now and review the basics of this concept. Once you understand it, I hope you will see how valuable putting your extra cash in an interest bearing account or investment is. I also hope you can apply the principle of TMV in your daily life.
For some of you this is a review. If you weren’t a business major, this may seem a bit foreign. Either way, it is very important stuff to understand because everyone has and needs to learn to deal with money.
You have an extra $1,000 sitting in your checking account that you never touch. If you moved that $1,000 into an account that earned 5% interest and didn’t touch it for 3 years, how much would you have after 3 years?
Present Value of your money is: $1,000
Value at the end of year 1: $1,000 * (1.05)= $1,050
Value at the end of year 2: $1,000 * (1.05)^2=$1,102.50
Value at the end of year 3: $1,000 * (1.05)^3= $1,157.63
Future Value of your money after 3 years: $1,157.62
You want to pay off your $5,000 student loan in 3 years. Assuming the loan accumulates no interest, how much would you need today in order to have $5,000 at the end of 3 years at 5%?
To answer this question, we need to flip the equation. Therefore, $5,000 is the Future Value of your money, we need to solve for the Present Value.
So if, FV= PV * (1 + i)^n
Then, PV= FV/ (1 + i)^n
(n=period, in this case years; i= interest rate)
PV= $5,000/ (1.05)^3
So you will need to start with $4,319.18 today to grow your account to $5,000 at 5% after 3 years.
How does saving $150 per month at 6% look after 5, 10, 20 and 30 years?
5 years: $10,466
10 years: $24,582
20 years: $69,306
30 years: $150,677
Plug in your own example using this calculator. Here’s how to fill in the calculator for this type of scenario:
PV= 0 (you start with nothing)
FV= leave blank (because this is what we are solving for)
Rate= interest rate
Periods= # of years you want to save*12 (i.e. period for 5 years is 60, or 5*12)
Drop Down Menu, select monthly (you will be contributing to this account each month). Then click FV to solve for Future Value.
The Rule of 72
The Rule of 72 is a popular way to quickly calculate how long it will take to double your money. It’s quite simple. All you do is take 72 and divide the interest rate you are getting, to find out how many years it takes to double your money.
So if you are earning 9% on your investment, 72/9=8 years
If you are earning 8% on your investment, 72/8= 9 years
In today’s economy, if you are earning 3% on your investment, 72/3= 24 years
If you have other scenarios that you’d like me to teach you to solve, send ‘em over. I’m happy to help!