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What is the Time Value of Money?
The time value of money is a concept which states that monetary resources are worth more in the present than they will be in the future. Therefore, individuals educated in this concept would always prefer to receive a payment now instead of at a later date. The principle of interest is central to this idea.
For the time value of money concept to hold true, one must assume that the funds in question will be invested and earn interest over time. Thus, $100 US Dollars (USD) that is invested today in an account earning a five percent interest rate will be worth $105 USD in one year. If this same amount was withheld for a year, outside of such an account it would still be worth only $100 USD at the end of that time span.
The value of any given amount of money will continue to increase over time, again assuming that the money is placed into an account where it will earn interest. The same $100 USD from the above example would be worth $125 USD at the end of five years, with the same five percent interest rate. This is known as the future value of money.
The present value of money, as it pertains to the time value of money concept, is slightly more difficult to calculate. The present value of a sum of money received today does not change. Therefore, $100 USD received today has a present value of $100 USD. However, the present value changes when you are referring to a sum of money that will be received in the future.
To determine the present value of money for an amount that will be received in a year, one must determine how much money would need to be invested today to yield that same final amount. That $100 USD no longer has a present value of $100 USD if it is going to be withheld for a year.
The present value of a sum of money that is withheld can be found by dividing the amount of money by the interest rate. At an interest rate of five percent, $100 USD that is withheld for a year has a present value of only $95.24 USD. This is because $95.24 USD, if received today and invested at a five percent interest, would yield $100 USD at the end of that year. The longer an amount of money is withheld, the more value it loses.
The popular expression “time is money,” is proven to be quite accurate when considering the time value of money. This concept is essential to understanding the importance of investments. By simply holding on to a sum of money in an interest bearing account, one can literally turn time into money simply by waiting.
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![For the time value of money concept to hold true, one must assume that the funds in question will be invested and earn interest over time.]()
By: gzorgzFor the time value of money concept to hold true, one must assume that the funds in question will be invested and earn interest over time.
Discussion Comments
@Iluviaporos - Most of the time when I hear this being discussed, it's to do with lottery winnings. Most lotteries give people the choice of either getting a lump sum, or receiving an annuity payment over a few decades.
In theory it makes more sense to get the lump sum, because you can get interest on it once it is invested, and you will also suffer loss through the depreciation of money that would likely happen over a few decades. There is also always the risk that the lottery would somehow go bankrupt or the payments would otherwise be disrupted.
However, I don't know if I would advise the average person to go for this option over the annual payments. It is extremely common for lottery winners to end up broke after a few years because they have no idea how to really comprehend and work with that amount of money. At least with an annual payment, you would almost be able to guarantee that you weren't going to go broke by spending beyond your means.
@clintflint - Most people are dealing with such small amounts in that case that I just don't think the risk is worth it though. If you manage to get an interest free loan there will almost always be some kind of catch, like a one-time fee or harsh penalties if you don't make payments on time.
If I have the money to make a full payment, I'd rather just do that, than take a chance on a small amount of interest.
This definitely makes sense to me. I don't know why people wouldn't prefer to have the money in their hand now, rather than deferring it until later, unless there was some kind of incentive to do that. Often the will offer to give you more money if you wait, which is one thing, but otherwise there is no reason not to accept the present value.
This is also why, if you can get a truly interest free loan, on, say, a car or something like that, you should take it. As long as you do everything right, you get to hold onto your money for a little while longer, which means more money for you.
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