The amount of money you have is not the only important factor to consider when growing wealth.
When you get it matters too.
The time value of money is the notion that money available in the present time is worth more than the same amount in the future, thanks to its potential to earn interest.
(And potentially earn other things in the meantime too.)
Let’s break that down.
Let’s assume we live in a world where, if you put money in the bank, you are guaranteed 10% interest.
10% is pretty high historically - but it will make our maths easier.
And then some fabulous individual gifts you some money.
Of the following scenarios, which would leave you better off?
- They could give you $100 right now.
- In one year, they could give you $109.
- Or in two years, they could give you $120.
You don’t have a terribly immediate need for the money, you just plan to save it.
And you know in the back of your mind, you can get 10% p.a. interest from the bank.
Which of those scenarios would you most like to have?
Because it is the largest figure, $120 might grab you.
But because you’re getting that in two years, you might feel like you’re missing out on something.
And you’d be right. You’d be missing out on the 10% p.a. interest you would get from storing it in the bank.
The sooner you get the money, and do something with it, the better.
- The interest you’d earn in the first year at 10% of $100 is $10.
- So, one year from now, you’d have $110 in the bank.
- Immediately, that’s more money than $109 (option 2).
You're better off by $1.
What about after two years?
- Well, the bank is going to give you another 10% interest on the second year.
- But this time, the 10% is on your $110, rather than the first $100.
- 10% of $110 is $11. So after two years, you’d have $121.
Once again you’re better off taking that $100 immediately, investing it in the bank at 10% and by the second year, you’ve got $121.
That’s a better situation than someone just giving you $120 after two years.
You're better off by $1.
So this idea that when you get money matters is called the Time Value of Money.
Or the value of money over time.
Present and future value
Because maths likes to work frontwards as well as backwards, let’s look at the Present Value.
The present value is a way of asking what money you need now to make sure you have an amount of money in the future.
Say you needed $121 in two years to buy...this Viridian Multifunction Rail Shower when it becomes available.
You need $121 two years in the future.
What amount of money would you have to put in the bank, at what interest rate, to get that amount?
We know that - it’s $100 at 10% p.a.
So the Present Value of $121 is $100 (at 10% p.a. interest).
You presently need $100 to have $121 in the future.