If you’ve ever heard the expression, “A dollar today is worth more than a dollar tomorrow,” then you know the basic definition of the time value of money. Essentially, having $1,000 today is more valuable than having $1,000 a year from now because of the potential for growth over that time period.
Other factors can also influence the time value of money, or TVM. For example, inflation naturally increases over time, and that can lower the purchasing power of future dollars. In short: Money you can put to work now is usually worth more than the same amount down the line.
Investors and business owners use TVM as a way to compare values of certain sums of money over different time periods.
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What Is the Time Value of Money?
The time value of money is the relationship between a dollar at one point in time and the value of that same dollar at another point in time. For example, $50 today likely won’t have the same value as $50 a year from now, just as $1 million now is not the same as $1 million 20 years ago (when a million dollars bought more than it does now).
You don’t need to know the formula for time value of money to understand the basic forces at play here. First, there is the potential for a present sum of money to earn a profit (if you invest it) or to gain interest (if you save it or buy debt instruments like bonds) over time.
Inflation is also an important consideration when calculating the time value of money. As goods get more expensive, each dollar will purchase less than it did the year before. For example, the historic rate of inflation is about 2% per year. If you consider how much $10,000 can buy today, it would buy roughly 2% less in a year — about $9,800 worth of goods.
So the time value of money is a framework for comparing lump sums of money and/or payments across different time periods. Dollars can be future, present, or past — almost like different currencies.
The definition of the time value of money may seem like a purely academic concept, but has many real-world applications. Time value of money is used in personal finance, real estate, and investing decisions.
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How Does Time Value Work?
The time value of money can look at both the present and future value of money and the value of cash flows. It allows both institutional and retail investors to compare payments or sums of money over different time frames.
Within a business context, calculating the time value of money using a TVM formula is important because it can help with decision making, e.g. about acquiring a new business or developing a new product. If you put $X amount of cash into a new line of business, what is the future value of that amount? And would the new investment equal or exceed it — or not (in which case it might not be a good use of your capital)?
To determine the value of money over periods of time, investors can use a formula that takes into account the present value and future value of a specific amount, and how it will change over time.
How to Calculate TVM for a Future Value
Quite often, investors are called upon to evaluate the future value (FV) of a present dollar amount. That formula is:
Where:
• PV – Present value of money
• FV – Future value of money
• i – interest rate or other amount that can be earned on the money
• t – number of years being considered
• n – number of compounding periods of interest per year
Let’s say you have $2,000 that’s earning 5% per year in interest payments. You could keep your money where it is, or you could consider another investment opportunity. In order to decide, it helps to know what the future value of your cash will be, given current parameters.
In this case, the calculation would look like this, employing the FV formula above:
This calculation tells you that your money is likely to be worth $2,205 in two years, assuming nothing changes. This could help you gauge whether the new opportunity would be likely to deliver a higher or a lower return.
How to Calculate TVM for a Present Value
It’s also possible to consider a future sum that’s being offered, and what that translates to in present dollars. Let’s say you could earn $2,000 now or be given $2,200 in a year. You’d need to calculate what the present value of $2,200 is.
To determine whether it makes sense to wait one year for an extra $200, here’s how to calculate the present value of that future amount, assuming you could earn 5% in the coming year.
In this case, the present value of the $2,200 being offered in one year is higher than taking just $2,000 now ($2,095). Which suggests that waiting to take the $2,200 payment might be a better move.
If there are multiple times per year when interest compounds, the result can be quite different. If interest compounds daily, monthly, quarterly or yearly can have a big effect on the TMV calculation (see below for more on compounding).
Why Is the Time Value of Money Important?
Time changes the value of money. Being able to calculate the present vs. the future value of money enables you to make better choices about how to invest and spend your money.
Therefore, TVM is inherently important in both an investing and a business context because it can help you gauge the value of different opportunities, and assess which makes the most sense financially.
Time Value of Money and Compound Returns
For the individual investor, there is perhaps no way in which the time value of money is more important than with the potential for earning compound returns.
To earn compound returns is to earn a rate of return on both the initial principal invested and all subsequent profits. As profits grow, so does the potential to earn more — and all that this exponential growth requires is that you stay invested.
The key to harnessing the raw power of compound returns is to spend as much time invested as possible — another example of the time value of money. Each year of positive returns is fuel for greater future returns.
This can be hard for investors to wrap their heads around because the results can take decades to reveal themselves. To understand compound returns, and the phenomenon of compounding in general, it helps to start with a comparison of simple and compound interest.
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Comparing Simple Interest to Compound Interest
With simple returns, a rate of return is produced on the principal investment in each period. An example is a basic Treasury note or bond that pays a 5% rate of return on $1,000 each year for five years. Each year the bondholder receives a $50 payment ($1,000 x 5%). The amount is not reinvested (i.e. there is no compounding), and at the end of five years the investor gets back the principal, and makes a profit of $250 (5 x $50) for a total of $1,250.
The time value of money has a bigger impact when you have a savings bond that pays 5% that compounds semi-annually. At the end of the five years, the investor’s initial $1,000 investment has grown to approximately $1,276. This is a total profit of $276, compared to simple interest’s $250. While this might not seem like much, this gap will continue to grow as compound return growth increases.
Likewise, the more frequent the compounding is, the greater the potential for growth would be. Thus compounding is an important factor in the time value of money as well.
Factors Affecting Compound Returns
There are four variables at play when calculating compound returns: the rate of return, the principal invested, the duration, and the frequency of compounding (e.g. monthly, quarterly, annually).
Check out a compound returns calculator for a better understanding of how these variables interplay. What you’ll find is that all factors can have a powerful impact on the time value of money.
Investors should also consider inflation. Inflation, or rising prices over time, also has a compounding effect. Investors can consider using a time value of money formula for inflation, and think about ways to hedge against inflation.
How Does Inflation Impact the Time Value of Money?
Inflation is another reason that money is typically worth more in the present than in the future. As time goes on, inflation erodes the purchasing power of money. So the same amount of money can’t buy as many goods in the future as it can today.
This is sometimes called inflation risk, and it refers to the need for investors to factor in the potential gains of an investment over time vs the impact of inflation, so they can protect their money. Invested money that gains more than the rate of inflation won’t lose value over time.
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Working With the Time Value of Money
Investors use the time value of money to understand the worth of money in relation to time, which helps them understand the value of their funds in the present and the future and how to invest them.
As noted above, factors such as interest rates, inflation, and risk all affect investments over time, so having formulas to help make decisions is a useful tool. Here are some other factors to consider.
Discount Rate
To decide whether the future cash flows from an investment will be worth more than the money required to fund the project now, in the present, you can use something called the discount rate. The discount rate is the rate of interest used to assess the present value (PV) of those future dollars.
For example, if you put $1,000 into an account or investment with a guaranteed 5% annual return, the future value of that money will be $1,050 in a year. So the discount rate in this case is 5%; you would discount $1,050 by 5% to arrive at its PV.
Sinking Funds
There is also the option to use the TVM calculation for so-called sinking funds, which is actually a savings strategy.
If you’re saving up for something in the future and know how much you need to save, you can figure out how much you need to save each month or year to reach that goal if you are earning interest on those savings.
Real Estate Investments
An investor might look at a property in a high-growth neighborhood and predict that it will be worth a certain amount in five years, but they want to calculate whether it is actually a good investment. They can use the TVM calculation to discount that estimated future value to find out the current value and see how the two compare.
Investing With SoFi
The time value of money (TVM) is an important concept for investors. It underscores the notion that time affects the value of money, along with other factors, and being able to calculate TVM in different scenarios, from investing to business, can help you decide whether one choice is likely to be more profitable over time.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Why use the time value of money concept?
A dollar now is almost always worth more than that same dollar in the future, owing to that dollar’s potential for growth (and the diminishing effect of inflation) over time. Using TVM formulas, it’s possible to gauge the long-term impact of different choices so you can make the more profitable one.
Is the time value of money concept always true?
Yes, for the simple reason that it’s always possible to invest your money now and gain some interest over time, even a minor amount.
What are some factors that may affect the time value of money?
The main factors that can impact the time value of money are the rate of interest, the number of years the money will earn that rate, and how often interest compounds.
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