March 31st, 2012

Youve probably heard that time is money and money is time. Well, its true! In financial circles, theres something called the time value of money. The time value of money is simply a concept to assign a worth to money based on different periods of time.

For example, we can ask if youre better off having $1,000 today or $3,000 in twelve years. Which is more valuable? To be able to answer that question, you have to be able to calculate the future value of $1,000 over a twelve-year span.

Lets examine the concept of future value. Well use our example of $1,000 now vs. $3,000 in 12 years. And lets assume that you expect to make 8% on your investments.

Figuring Future Value (FV):

Equation: FV = Original Amount x (1 + interest rate) time

Plug in your numbers: FV = $1,000 x (1 + 0.08) 12

This means that $3,000 in twelve years is more valuable because $1,000 now would only be worth $2,518.17 in twelve years. 

Present Value

Just as money has a future value, it also has a present value. Using this concept, you can also solve the dilemma above by calculating the present value of the $3,000 that youd receive twelve years in the future.

Present value looks at an amount of money to be received in the future and determines what it would be worth now.  

Lets imagine you were going to receive $5,000 in five years. What would that be worth now? This is really just the reverse of finding the future value. Lets use an interest rate of 7%.

Figuring Present Value (PV)

Equation: PV = FV / (1+interest rate) time

Plug in Your Numbers: PV = $5,000 / (1+0.07) 5

Calculate Answer: PV = $3,564.93

This means that $3,564.93 today would have the same value as $5,000 earned in five years. 

Dont let these equations intimidate you. Calculators and spreadsheets make them a snap. Financial math is often quite simple, even if the exponents look daunting.

Now that you have these equations at hand, lets see what they can do for you personally. To start with, you could calculate what your investments will be worth in a certain number of years. You could also figure out what your savings account would be worth 20 years from now.

Lets suppose you wanted to have a million dollars in the bank in 25 years. Youd want to calculate how much money you would need now to make that happen in the given period of time. You could also look at the amount of money required to make a million dollars sooner than that.

Here are some of the most common situations where these calculations would be useful:

• Student loans
• Savings accounts
• Credit cards
• Mortgage payments
• Retirement planning
• Investments

Retirement planning is probably the most common activity for using these concepts. Try playing with a few examples from your own life. Figure out how much your 401k would be worth in the future if you never deposited another dime in the account. Investigate the future value of all your retirement investments.

However you go about using these equations, now you can calculate exactly what time is really worth to you, in terms of money. By utilizing the concepts of future value and present value, youll never need to be confused again when youre comparing financial options. Dig into the math and apply it to you own life. Theres no better way to learn.