I’m going to give you $1,000 and you have two options.
Option 1: You can take the money today.
Option 2: You can take the money 1 year from now.
Which option do you choose? Let’s reason it out.
Option 1
If you take the money you can spend it today. You can pay off your rent, buy groceries, and even invest it. Sounds pretty good right?
Option 2
Perhaps you don’t need the money right this instant and can wait one year. Next year you will buy a car or house and the money will come in handy. Even if you put it in your savings account today you wouldn’t spend it so taking it next year is completely fine right?
So, which option is it?
Both options are logical but there is a clear winner here. The winner is option 1 because of the following concept: time value of money (TVM).
Money today is ALWAYS worth more than in the future. This is what TVM says and if you consider this concept while making financial decisions I guarantee you will have more money in the future.
Why is $1,000 worth more today than in one year?
There are two reasons, the first being inflation. Every year inflation increases by about 3% meaning that anything which cost $1 today will cost $1.03 next year. Essentially $1 is worth 97 cents if you just leave the money sit, inflation will eat it.
The second reason money is worth more today is due to its growth potential through investing. Put that $1,000 in the stock market today and next year you can have $1,070. A 7% return on the stock market is something anybody can do by simply investing in an index fund through Vanguard, Betterment, or any other easy to use investment application.
Then the question becomes, do you want $1,000 in one year or $1,070? Clearly you would take the $1,070.
Now let me ask you this. Do you want $1,000 now or $1,070 in one year? It doesn’t matter! Assuming you can get 7% on your investment they are both worth the same amount of money, just at different times.
You have to be extremely precise when it comes to the TVM! Even if I offered you $1,069 one year from now as opposed to the $1,000 today you are still losing money. It is really tempting to take the $1,069 because it seems to be worth more than $1,000 today but it actually isn’t.
Using This In Real Life
You make transactions almost every single day and now that you know the TVM concept you can use it to your advantage. If you are buying something try to give the money at some point in the future because the money will be worth less and in the meantime you can take that money and earn more. If selling something try to get the money today because you can start investing today.
The Equation
Understanding this concept is great but you really need to know the equation to calculate your earning potential. There are four variables in the TVM equation:
- Future Value (FV)
- Present Value (PV)
- Interest Rate (r)
- Number compounding periods (t)
The equation looks like this…
FV=PV*(1+r)^t
From the example above we can fill in the variables with actual numbers.
$1,070=$1,000*(1+7%)^1
If you want to know what the $1000 is worth in five years just plug it in to the equation.
FV=$1,000*(1+7%)^5
FV=$1,402.55
The easiest way to do this is to use Microsoft Excel or Google Sheets but you can also use a financial calculator. I recommend the Texas Instruments BA II Plus which you can purchase on Amazon.
The easiest way to think about the value of money is by putting it on a timeline and figuring out your variables. Period 0 is the present value and the desired ending period goes on the opposite end.
One important thing to keep in mind is to make sure the interest rate (r) and number of compounding periods (t) match. 7% compounded annually every 5 years means interest is 7% and t is 5. 7% compounded semi-annually for 5 years means compounded twice every year for a total of 10 times. In this case r = 7% and t = 10.
Live and Breathe TVM
Understanding TVM and applying it to your life is something you should do if you want to be successful financially. Every time you decide to spend money on things that you don’t need to think of TVM. If you don’t spend $5,000 on leather seats for your new car today what could you have in the future? These are all decisions you have to make based on your lifestyle.
Leave a comment below to share your thoughts on the time value of money and share this article with anybody who could find it helpful! My goal is to share this with as many people as possible to make their lives better.
