Time value of money: definition, formula, example

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  • The Time Value of Money (TVM) is the concept that a dollar today is worth more than a dollar tomorrow.
  • Understanding TVM allows you to assess financial opportunities and risks.
  • The principle underlies almost every financial and investment decision you make.

Time Value of Money (TVM) is the concept that the money you have in your pocket today is worth more than the same amount if you received it in the future because of the profit it can generate during the interval.

For example, let’s say you can either receive a payment of $100,000 today or $10,000 per year for the next ten years, for a total of $100,000. Excluding taxes, the $100,000 payout today is worth more, according to the TVM principle, because you can put your money to work. For example, you can invest in stocks, buy real estate, or put it in a certificate of deposit (CD).

Understanding the time value of money can help you make decisions ranging from which job has better pay conditions, what’s a good rate for a loan, or whether the investment you’re considering has good growth potential.

How does the time value of money work?

The time value of money is an important concept to keep in mind because your money, once invested, can grow over time. Even if you were to just put it in a CD or savings account, the money can earn compound interest.

On the other hand, money that is not invested will lose value over time. Just think about what you could buy for $1 when you were a kid versus what that same $1 would get you today. This is because inflation and loss of potential income erodes the value of your dollars. If you keep your money under your mattress for 10 years, not only will it be worth less due to inflation, but you will also miss out on the interest it can earn when invested.

“So many young people are so busy juggling life that they miss out on the compound returns of investing small amounts of money,” says Jeff Rose, founder of GoodFinancialCents.com. “Let’s say, for example, that a 25 year old invests $50 a month today, he would have to invest 3 to 4 times as much to make up the difference if he procrastinates until he is 35.

TMV is a fundamental concept that forms the basis of virtually all financial and investment decisions. Whether it’s taking out a loan, negotiating a salary, or making a purchasing decision, use the time value of money to assess the best financial course of action.

How to Calculate the Time Value of Money

Now that you understand what the time value of money is, let’s look at a concrete example. Let’s say someone would like to buy your car and can offer you $15,000 today or $15,500 if they can pay you in two years. TVM tells us that $15,000 today is worth more than $15,500 two years from now.

Here is the basic formula for calculating the future value of money:

Formula for the Future Value of Money


Initiated


  • PV is the present value of money.
  • I is the rate of interest or other return that could be earned.
  • you is the number of years to consider.
  • not is the number of compound interest periods per year.

This will help you determine how much money you will have if you took the $15,000 and invested it today or waited two years for the $15,500.

The bottom line

The time value of money is an important concept to understand for personal finance. It can help you decide how much to budget, evaluate a job offer, determine if a loan is a good deal, and save for the future. TVM shows why your money loses value over time due to inflation.

Apply the TVM formula to all the loans you have to determine if it is better to pay them back or to invest. You can also use it to see how increasing your pension contributions may affect the future value of your dollars. It’s a great tool that gives you information that can help you make smarter financial decisions.

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