Time Value of Money (TVM) - what is Time Value of Money?
Time value of money (TVM) is a financial principle that asserts that money available in the present is worth more than the same amount of money in the future because of its potential earning capacity so long as the money earned in the present is able to earn interest.
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That sounds great, but break it down a bit more for me...
I'm glad you asked! Before you figure out how to work out the possible value, you need to bear 4 things in mind:
- Present Value - the amount you start with. The amount in your pocket, or your wallet, and the amount you can invest for the future.
- Future Value - the amount you end up with at some point in the future. Ideally it ends up being more than what you started out with and has been earning some form of interest for the time period where you invested it and left it alone to mature.
- Timescale - how long are you going to leave this invested money to earn interest? In a negative context, it could also mean a debt - how long are you going to leave it before you start paying it off? This is most often measured in months or years, but can sometimes be weeks. Some investment accounts will have certain requirements (such as an ISA) where you have to leave the money in the account for a longer period of time to get a better rate of return.
- The interest rate - how much your money will earn for the length of time you invest it. At the moment (as of 2018), it's a measly 0.5% or less.
How does Time Value of Money affect investments?
Let's say you have £300 you'd like to invest, and (be optimistic) that the best interest rate you could get was 5% per year (known as annual interest). This means that if you invested the original £300 and left it for a year, you would end that year with £315. If you left the same £300 for 3 years, you'd end up with a total of £345.
How does Time Value of Money affect debts?
What the debt is for, how much debt you owe, and how long the debt will be outstanding will all be factors to consider. If the interest rate on the debt is particularly high, it might make more sense to begin to pay it off as aggressively as possible so you can get rid of it in the quickest amount of time.
If the debt will be forgiven or written off at some point (such as a student loan in the UK), then only minimum payments might be necessary, and you can focus some attention on building an emergency fund, or investing some money.
Before going into debt (such as a credit card), it is worth thinking about whether;
- the extra payments (plus the interest) you'll need to make on it are worth it compared to what you've purchased.
- you are comfortable enough with giving up the amount of interest that could have been earned on the money if you had invested it instead.
- getting the thing you want to buy is more important, or in line with your overall financial goals compared to saving or investing the money.
TVM is not something that the majority tend not to consider, as the need for money is usually more of an urgent need, (bills, rent, chlid care, transport etc)- so investing money can often take a backseat and is something that’s done occasionally. The point being: life gets in the way. However, it’s always good to keep in mind, even when dealing with debts, depending on the repayment terms you can negotiate.