Time Value of Money – Explained

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One area that a lot of people struggle with is understanding the time value of money – often when someone mentions this concept a lot of people take it as a signal to stop paying attention.

There are 4 concepts that you need to get your head around to understand the time value of money

  • Compounding
  • Discounting
  • Present Value
  • Future Value

Compounding

Compound interest is when your interest also earns interest. So if you have savings earning 10% in the first year you will receive €10 Interest and then in the second year you will receive €11 in interest (110*10%)

Discounting

Is the opposite of compounding. It is calculating the value you need to have on deposit today to get €110 in the future.

Present Value

Present value is the value today of an amount in the future.

What would you prefer – to receive €100 today or receive €100 in a years time?

Automatically the answer is €100 today as you could put that €100 in a deposit account at 4% and it will be worth €104 in a years time, instead of €100.

Or to put it another way what would you prefer – to pay €100 in a years time or pay it today?

Again the answer is automatically a years time. As you could put €96 into a savings account today and it will be worth €100 in a years time.

So getting €100 next year is only worth €96 today. This is called the present value.

Future Value

The future value is what your money will be worth in a years time compounded at the interest rate it is earning.

The future value of €100 compounded by 4% over a year is €104.

 

Use in the Real world

The time value of money is one of the building blocks of finance and it can get more complicated when you take into account inflation, cashflows at different times and different rates of return over the course of an investment – however, if you can get your head around the above example you will have a greater understanding of finance than most.

By understanding the time value and how to discount and compound money can make a huge difference to your financial health over the course of your life, as it can be used to calculate return on investments and in all aspects of personal finance.

First Job – 3 Financial Steps to Take

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You have done the hard work and secured your first step on the career now its time to make smart choices.

Join the company pension scheme – This is something a lot of 20 somethings won’t bother with or prioritise but by contributing to your pension now will save you a lot of money in the future. Due to the power of compounding – the longer you give your money to grow the more you will have in 40 years. Often large corporates in Ireland match your contributions so if you give 5% of your salary they will give 5% – ensure that you don’t lose out on matching contributions.

For example if you are a newly employed graduate on a starting salary of 21000 and you employer offers to match your contributions to your pension up to 5%. It will cost you just €66 a month to contribute €175. This may not seem like much but if you contribute for a year then stop that is €2100 which could grow to €45621 by the time your 60 if you average a return of 8%. If you continue contributing the same amount throughout your working life and it achieves the same average return of 8% this €66 monthly cost to you would grow to over €500,000.

In your 20’s between you and your employer you can contribute up to 15% of your salary to you pension and still avail of tax benefits.

Get Mortgage ready –Nearly every Irish person in their 20’s aim to get on the property ladder as soon as possible. Give your self the best chance by starting a savings habit that will build your deposit and also prove to the banks you will be able to meet mortgage repayments. Avoid building up credit card debt or becoming overdrawn as well as setting up a direct debit to you savings account every month. Check out our regular savings comparison table to find the best rate.

Avail of any benefits offered by company – Find out what benefits your employer offer and make sure you avail of them. Some companies offer health insurance/dental insurance/travel insurance make sure you are registered as soon as possible on the company scheme and make sure you are not double insured on any of these. Avail of the tax saver on your commuter ticket or the cycle to work schemes.