Time Value of Money
Given a choice, earning $100 today is preferable to earning $100 a year from now. If you earn $100 today, you can spend it or invest it. If you earn $100 a year from now, you must defer spending for a year. You also miss an opportunity to invest it.
This is an example of the time value of money, a fundamental principle of budgeting and investing. The time value of money varies for most of us; it is personal. However, a society's economy determines a general time value of money through the level of interest rates. A common interest rate for measuring time value of money is the rate of return you can safely earn on an investment, with no risk of losing your original investment.
Let's call the $100 you can earn today the present value of a future amount. Let's call the amount you can earn in the future the future value. Interest rates connect present and future values. To be compensated for the time value of money, you require a certain interest rate.
Generally, the market interest rate determines the time value of money in society. This rate is determined by the interaction of demand and supply for funds in the economy. In the U.S., a 5% annual rate might be adequate compensation. In Brazil, where a higher rate of inflation erodes the future value of money, a 15% annual rate might be the market interest rate.
For example, if you deposit the $100 in a certificate of deposit (CD) that earns 6% annual interest, the future value in a year is $106 ($100*1.06). In this case, earning $106 a year from now is enough to compensate you for not spending $100 today. The $6 in interest represents the time value of money.
On the other hand, if the interest rate you require is higher, a 6% interest rate won't earn enough interest to compensate you. In this case, spending the $100 has more value.
As you can see, the time value of money is determined by the level of market interest rates. If interest rates (and inflation) are low, the time value of money is relatively low. If interest rates are high, the time value of money is relatively high. The following table illustrates the time value of $100 at different interest rates for one and two years:
For example, $100 today would only be worth $94.34 a year from now if the market interest rate were 6%. Two years from now, $100 would only be worth $89, if the interest rate remained at 6%.
For the first example, enter $94.74, 9%, and 1 year in the first, second, and fourth boxes. Enter a zero in the other boxes. Then, view Results by clicking the tab, which show $100. Interpretation: the time value of $100 for one year, at 9% interest, is about $8 ($100-$92).
Let's try a second example, using a different interest rate and number of years. Enter $89, 6%, and 2 years in the first, second, and fourth boxes. Leave the zeros in the other boxes. Results show $100. Interpretation: the time value of $100 for two years, at 6% interest, is about $11 ($100-$89).
Time value of money has many useful applications. One of the most important uses is that it helps you to measure the trade-off in spending and saving. This can have important consequences for your personal budgeting. If market interest rates are at 5%, you may decide that the time value of money is greater in the future, and decide to invest. If rates are a meager 2%, you may decide that the time value of money is higher today, and choose to spend.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.