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
- Present Value
- Future Value
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%)
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 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.
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.