The most basic law in finance!

The time value of money states that a dollar

today is worth more than a dollar at some time in the future. Okay, it’s not that
simple to understand at first glance so let me delve into this advice a little with
some financial examples:

If I invest $1,000 in a 5% savings account today, it will be worth $1,050 in one

year. Therefore, if I can have $1,000 today or choose to have $1,000 one year
from now, it is always better to have the money now. By saving and investing
today, you make the time value of money work for you.

Let’s look at the reverse of this, to see how the time value of money can work
against you. Suppose instead of receiving $1,000 that you spent $1,000 by
purchasing merchandise on your credit card. Remember that a dollar today is
worth more than a dollar tomorrow, so in this case, you will have lost money
because you will need to pay off your credit card account with money from the
future (which is worth less than money today). In addition to having to pay with
future money, you will also have to pay interest expense. So, in this case, if you
paid off the credit card in one year (assuming 15% interest), you’d have to pay
$1,150.

You should think about the time value of money before making any decisions.
Another, maybe even more important concept related to the time value of
money is the compounding effect of money.

The compounding effect of money is extremely important when making any

financial decision. The compounding effect of money is often overlooked or
underestimated by people when making decisions. When applied to all of your
financial decisions, this effect is the KEY to long-term success! To illustrate the
compounding effect of money, let me use some financial examples:

Suppose you had invested $1,000 today in a 5% savings account. In one year,
that account would be worth $1,050 [$1,000 + ($1,000 x 5%)], yielding a $50
gain. However, in year two, that same initial investment would be worth
$1,102.50 [$1,000 + ($1,000 x 5%) + ($1,050 x 5%)], yielding a $52.50 gain.
And in year three, the same $1,000 would be worth $1,157.63, yielding a $55.13
gain. By year ten, the initial $1,000 investment would be worth $1,629 and by
year 25 it would be worth $3,386.

From looking at this example, you can see that investing $1,000 today is much
more valuable than investing $1,000 even a couple of years from now. To
accumulate wealth, you MUST use the time value of money and the
compounding effect of money to your advantage.
This second example shows how the compounding effect can work against you:
Suppose you borrowed $20,000 to purchase a car and your auto loan was at a
10% interest rate (for 5 years). Your monthly payments would be $424.94.
Because the $20,000 loan continues to compound over the life of the loan, you
actually pay $25,496.45 over the five-year period, meaning that you’ve in
essence paid $5,496.45 because you spent the money before you had it. In fact,
in your initial payments, the interest alone will account for almost 40% of your
monthly payments. In this case, the bank or lender that gave you the loan uses
the time value of money to their advantage.

Now look at this scenario, where instead of making the $424.94 car payment,
you invest that payment at the same rate as what your car loan was (granted it’s
a little high for a savings rate, but not unreasonable for other investments).
Now, instead of paying the bank, you are actually earning interest and
compounding the benefit yourself. After one year you will have saved $5,340
and have earned $240 in interest. After two years, you will have saved $11,239
and have earned $1,039 in interest. By the third year, your investments will be
worth almost $18,000 and you will have earned $2,457 in interest. By month 40,
you will have enough money to purchase a $20,000 car in cash!

So let’s weigh the differences between the two scenarios above. In the first case
you paid the bank $5,496 to borrow the money and in the second case you
earned $2,457 and could buy the car in cash after just 40 months (just over 3
years)! The opportunity cost of the first alternative versus the second alternative
results in a net difference of $7,953 (a $2,457 gain versus a $5,496 loss). That
means that by making a simple deferral decision (buying the car in 3 years
versus today), you can get ahead by almost $8,000!

If you want to build wealth you need to take risks. The higher level of risk that
you take, the higher your return should be. With that said, only take the risks
that are appropriate to you! For example: You have the choice of investing in a
savings account, a money market account, a certificate of deposit (CD), a bond
fund, a large cap stock fund and an aggressive mutual fund (mostly tech stocks).
Each investment has a different level of risk and each investment makes sense
for different people. Typically, the higher level of risk that you take, the higher
your potential investment return. The right investment for you depends on many
things, but the two most important factors are 1) your realistic time horizon, and
2) your aversion to risk. Regarding time horizon, if you have 40 years to
retirement, you should invest your money in the highest risk, highest yielding
sectors (maybe 70% stocks, 15% bonds and 15% money markets). But if you
are close to retirement or can't afford to risk your investments, the majority of
your investments should be allocated toward the low-risk investments such as
savings accounts, money market accounts, CDs and maybe even a bond fund.
Regarding risk aversion, you must make this decision yourself. If you have
trouble sleeping at night because you're investing in stocks, you should probably
sway toward the lower risk investments.
The major takeaway from this section is that it is important to take risks. The
more risk you take the more you can expect to earn and accumulate over the
long-term. However, be conscious of yourself and your goals and do not take
more risk than your time horizon or your own personality will allow.

Congratulations!!! You have won a cash prize! You have two payment options:

A. Receive $10,000 now

OR

B. Receive $10,000 in three years

Which option would you choose?

What Is Time Value?

If you're like most people, you would choose to receive the $10,000 now. After all, three
years is a long time to wait. Why would any rational person defer payment into the future
when he or she could have the same amount of money now? For most of us, taking the
money in the present is just plain instinctive. So at the most basic level, the time value of
money demonstrates that, all things being equal, it is better to have money now rather
than later.

But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't
it? Actually, although the bill is the same, you can do much more with the money if you
have it now because over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future
value of your money by investing and gaining interest over a period of time. For Option
B, you don't have time on your side, and the payment received in three years would be
your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest
acquired over the three years. The future value for Option B, on the other hand, would
only be $10,000. So how can you calculate exactly how much more Option A is worth,
compared to Option B? Let's take a look.

Future Value Basics

If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the
future value of your investment at the end of the first year is $10,450, which of course is
calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5%
and then adding the interest gained to the principal amount:

Future value of investment at end of first year:

= ($10,000 x 0.045) + $10,000
= $10,450

You can also calculate the total amount of a one-year investment with a simple
manipulation of the above equation:

• Original equation: ($10,000 x 0.045) + $10,000 = $10,450

• Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
• Final equation: $10,000 x (0.045 + 1) = $10,450

The manipulated equation above is simply a removal of the like-variable $10,000 (the
principal amount) by dividing the entire original equation by $10,000.

If the $10,450 left in your investment account at the end of the first year is left untouched
and you invested it at 4.5% for another year, how much would you have? To calculate
this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of
two years, you would have $10,920:

Future value of investment at end of second

year:
= $10,450 x (1+0.045)
= $10,920.25

The above calculation, then, is equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x (1+0.045)

Think back to math class and the rule of exponents, which states that the multiplication of
like terms is equivalent to adding their exponents. In the above equation, the two like
terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can
be represented as the following:

We can see that the exponent is equal to the number of years for which the money is
earning interest in an investment. So, the equation for calculating the three-year future
value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first
year, then the second year, then the third year, and so on. If you know how many years
you would like to hold a present amount of money in an investment, the future value of
that amount is calculated by the following equation:

Present Value Basics

If you received $10,000 today, the present value would of course be $10,000 because
present value is what your investment gives you now if you were to spend it today. If
$10,000 were to be received in a year, the present value of the amount would not be
$10,000 because you do not have it in your hand now, in the present. To find the present
value of the $10,000 you will receive in the future, you need to pretend that the $10,000
is the total future value of an amount that you invested today. In other words, to find the
present value of the future $10,000, we need to find out how much we would have to
invest today in order to receive that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today, you must
subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we
can discount the future payment amount ($10,000) by the interest rate for the period. In
essence, all you are doing is rearranging the future value equation above so that you may
solve for P. The above future value equation can be rewritten by replacing the P variable
with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to
be received in three years is really the same as the future value of an investment. If today
we were at the two-year mark, we would discount the payment back one year. At the two-
year mark, the present value of the $10,000 to be received in one year is represented as
the following:
Present value of future payment of $10,000 at end of year
two:

Note that if today we were at the one-year mark, the above $9,569.38 would be
considered the future value of our investment one year from now.

Continuing on, at the end of the first year we would be expecting to receive the payment
of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value
of a $10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of
the investment every year counting back from the $10,000 investment at the third year.
We could put the equation more concisely and use the $10,000 as FV. So, here is how
you can calculate today's present value of the $10,000 expected from a three-year
investment earning 4.5%:
So the present value of a future payment of $10,000 is worth $8,762.97 today if interest
rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now
and then investing it for three years. The equations above illustrate that Option A is better
not only because it offers you money right now but because it offers you $1,237.03
($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you
receive from Option A, your choice gives you a future value that is $1,411.66
($11,411.66 - $10,000) greater than the future value of Option B.

Present Value of a Future Payment

Let's add a little spice to our investment knowledge. What if the payment in three years is
more than the amount you'd receive today? Say you could receive either $15,000 today or
$18,000 in four years. Which would you choose? The decision is now more difficult. If
you choose to receive $15,000 today and invest the entire amount, you may actually end
up with an amount of cash in four years that is less than $18,000. You could find the
future value of $15,000, but since we are always living in the present, let's find the
present value of $18,000 if interest rates are currently 4%. Remember that the equation
for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment.
Using the numbers above, the present value of an $18,000 payment in four years would
be calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or
$15,386.48 today. Of course we should choose to postpone payment for four years! (For
related reading, see Anything But Ordinary: Calculating The Present And Future Value
Of Annuities.)

Conclusion
These calculations demonstrate that time literally is money - the value of the money you
have now is not the same as it will be in the future and vice versa. So, it is important to
know how to calculate the time value of money so that you can distinguish between the
worth of investments that offer you returns at different times.
illustrate, we have provided a timeline: