Understanding the Time Value of Money: Key to Making Smart Financial Decisions

Which holds more value: $100 today or $100 a year from now? Does it depend on whether you’re making or receiving the payment? Your answer might hinge on your understanding of ‘the time value of money.’ So, let’s explore this financial concept and understand why is the time value of money important for making savvy monetary decisions. Throughout this exploration, we’ll refer to some time value of money examples and use a time value of money calculator to illustrate our principles clearly.

Time value of money concept

Understanding the Time Value of Money

Consider this situation: you can take a lump sum of money now or wait a year to collect it. Most people would choose the money now because they have immediate needs or wants that the money can fulfill. But what if the future sum is significantly larger? At what point would your decision shift?

This intuitive understanding that $1 today is worth more than $1 tomorrow, and even more than $1 a year from now, is the essence of the time value of money concept. The time value of money importance is seen in situations like installment loans, such as mortgages or car payments. It’s also crucial for interest-bearing accounts like an IRA. If you decide to invest in real estate, you’ll need to be proficient with these concepts to accurately calculate the time value of money for your cash flows and principal.

How to Calculate the Time Value of Money?

To calculate the time value of money, you need to know and understand a few terms.

  • Present value. This is the sum of money you have today.
  • Future value. This is the sum of money you will have at some later time.
  • A discount rate is the percentage rate used to determine the present value of the future amount. It can often be approximated at the interest rate.

Risk and opportunity cost – two main factors when considering the discount rate

  • Risk: The more risk you take on, the higher return you will expect.

Time value of money real-life example, if you put $100 in a bank, you may be willing to accept a $5 return on an investment after a year. This is because the risk that the bank will not repay you is low. If you lend the same $100 to a stranger, you may require a $20 return on investment instead. The person is a stranger. You do not know if they will or will not repay you. To take that level of risk, you require them to pay you $20 extra to use your money.

  • Opportunity Cost: The opportunity cost is the cost of the benefit lost by choosing one option over the other(s). If you have the money available right now, you can invest it immediately or apply it elsewhere. Let’s say you choose to apply it somewhere else. The opportunity cost is the value of the interest you could earn while the money is invested.

Time value of money calculations

Given the present value of some money and the discount rate, you can find the future amount using

Future Value = Present Value x (1+Discount Rate)

Let’s say you know how much you want to make, and you know the discount rate you’ll get. If you want to know how much money you’ll need for the initial investment, use

Present Value = Future Value ÷ (1+ Discount Rate)

Let’s use an example to drive the point home. You have $1000 today that you can invest for a year at a 7% discount rate (the interest rate). The value of that $1000 one year from now is

Future Value = $1000 x (1 + 0.07) = $1000 x 1.07 = $1070.

To have $1000 today, you must invest a year ago. Your future value is now $1000; you would use the same discount rate. At that time, your present value would have been

Present Value = $1000 ÷ 1.07 = $934.58.

What if you wanted to project the value of your money beyond a year? For the future value of your $1000, you use

Future Value = Present Value x (1 + Discount Rate)(number of time periods)

So the future value of your $1000 after 5 years, assuming a 7% discount rate per year, would be

Future Value = $1000 x (1 + 0.07)5 = $1000 x 1.40255= $1,402.55.

Similarly, you can rearrange the formula if you want the initial investment needed to earn $1000 in 5 years. Assuming the same interest rate, your future value will be $1000, and your present value will be

Present Value = $1000 ÷ (1 +0.07)5 = $1000 ÷ 1.40255 = $712.99.

You would have had to invest $712.99 five years ago at a 7% interest rate to have $1000 today.

Time Value of Money Real-Life Examples

Time value of money_ 3 real-life examples inside

We can use the time value of money in everyday money decisions. Take, for example, the following situations:

Scenario 1 You’ve finally won the lottery! 

The lottery commission lets you choose how you would like to be paid. You can receive $1000 per week for life or an immediate lump sum settlement of $1.5 million. What would be the best option? There is no straightforward answer to this situation. Your answer would depend on a few factors that are specific to your life situation, such as:

    • Your age and your life expectancy. If your life expectancy is short, you may not get the full value of your winnings at $1000 weekly.
    • What current investment opportunities are available to you? Taking the lump sum but having nothing to invest it in may not be worthwhile.
    • The stability of the organization making the payments. Will the lottery commission be around “for life”?

Once you develop the discount rate, you can use the following calculators to help calculate the better payout for you.

Future Value of Present Sum Calculator Online

Future Value of Present Sum

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Present Value (PV):
Rate (R):
Payments (PMT): 0
Periods (q):
Inflation Rate:
Future Value (FV) of Present Sum:

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By using this calculator you agree to terms and conditions. These calculators are designed to be informational and educational tools only, and when used alone, do not constitute investment or financial advice. We strongly recommend that you seek the advice of a financial services professional before making any type of investment or deciding on your financial matters. This model is provided as a rough approximation of future financial performance. The results presented by this calculator are hypothetical and may not reflect the actual growth of your own investments. We can't take into account potential lender fees, payoff schedule can be longer than in the estimation. Financialfreedom and its affiliates are not responsible for the consequences of any decisions or actions taken in reliance upon or as a result of the information provided by these tools. Financialfreedom is not responsible for any human or mechanical errors or omissions.

Future Value of Cash Flows Calculator Online

Future Value of Cash Flows Calculator

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Present Value (PV):
Rate (R):
Payments (PMT):
Periods (q):
Inflation Rate:
Future Value (FV) of Cash Flow:

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Savings Schedule

Number Deposit Total
- - -

Remaining Loan Balance

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By using this calculator you agree to terms and conditions. These calculators are designed to be informational and educational tools only, and when used alone, do not constitute investment or financial advice. We strongly recommend that you seek the advice of a financial services professional before making any type of investment or deciding on your financial matters. This model is provided as a rough approximation of future financial performance. The results presented by this calculator are hypothetical and may not reflect the actual growth of your own investments. We can't take into account potential lender fees, payoff schedule can be longer than in the estimation. Financialfreedom and its affiliates are not responsible for the consequences of any decisions or actions taken in reliance upon or as a result of the information provided by these tools. Financialfreedom is not responsible for any human or mechanical errors or omissions.

Scenario 2 You are receiving a payout which is worth $100 today

If taken later, this same payout will be worth $110. When making your decision, consider the following:

  • Where is the interest coming from?
  • Where can you invest that $100 today, and how much would it be a year from now?

TMV Calculators to help you decide:

Present Value of a Future Sum

Present Value of a Future Sum

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Table

Present Value (PV):
Rate (R):
Payments (PMT):
Periods (q):
Inflation Rate:
Future Value (FV):

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Savings Schedule

Number Deposit Total
- - -

Remaining Loan Balance

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By using this calculator you agree to terms and conditions. These calculators are designed to be informational and educational tools only, and when used alone, do not constitute investment or financial advice. We strongly recommend that you seek the advice of a financial services professional before making any type of investment or deciding on your financial matters. This model is provided as a rough approximation of future financial performance. The results presented by this calculator are hypothetical and may not reflect the actual growth of your own investments. We can't take into account potential lender fees, payoff schedule can be longer than in the estimation. Financialfreedom and its affiliates are not responsible for the consequences of any decisions or actions taken in reliance upon or as a result of the information provided by these tools. Financialfreedom is not responsible for any human or mechanical errors or omissions.

Present Value of Cash Flows

Present Value of Cash Flows

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Table

Present Value (PV):
Rate (R):
Payments (PMT):
Periods (q):
Inflation Rate:
Future Value (FV):

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Savings Schedule

Number Deposit Total
- - -

Remaining Loan Balance

Save as PDF

By using this calculator you agree to terms and conditions. These calculators are designed to be informational and educational tools only, and when used alone, do not constitute investment or financial advice. We strongly recommend that you seek the advice of a financial services professional before making any type of investment or deciding on your financial matters. This model is provided as a rough approximation of future financial performance. The results presented by this calculator are hypothetical and may not reflect the actual growth of your own investments. We can't take into account potential lender fees, payoff schedule can be longer than in the estimation. Financialfreedom and its affiliates are not responsible for the consequences of any decisions or actions taken in reliance upon or as a result of the information provided by these tools. Financialfreedom is not responsible for any human or mechanical errors or omissions.

Scenario 3 You’re going to get an extra $1,000 on your tax refund

You can do many things with that money, but you’ve narrowed it down to two choices. Should you invest the $1000 for the next 20 years or use it to pay your mortgage today? When you make your decision, you should think about the following:

  • Your current and future mortgage rates.
  • The investment opportunities for this money.

Potentially you can decide to invest this money into a stable bond. You can use this calculator to decide how much this annuity is worth.

Annuity Future Value Calculator Online

Annuity Future Value Calculator

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Present Value (PV):
Rate (R):
Payments (PMT):
Periods (q):
Inflation Rate:
Future Value (FV) of Ordinary Annuity:

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Savings Schedule

Number Deposit Total
- - -

Remaining Loan Balance

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By using this calculator you agree to terms and conditions. These calculators are designed to be informational and educational tools only, and when used alone, do not constitute investment or financial advice. We strongly recommend that you seek the advice of a financial services professional before making any type of investment or deciding on your financial matters. This model is provided as a rough approximation of future financial performance. The results presented by this calculator are hypothetical and may not reflect the actual growth of your own investments. We can't take into account potential lender fees, payoff schedule can be longer than in the estimation. Financialfreedom and its affiliates are not responsible for the consequences of any decisions or actions taken in reliance upon or as a result of the information provided by these tools. Financialfreedom is not responsible for any human or mechanical errors or omissions.

Make Better Financial Decisions With Financial Freedom Guru

The time value of money concept is fundamental to making wise financial decisions, especially when deciding between two or more financial options. Should you take the money now, or would it be more beneficial to collect it later?

The answer relies on numerous factors tied to your circumstances. Irrespective of the option you favour, understanding the definition of the time value of money enables you to comprehend just how much is at stake. With tools like a time value of money calculator, you can also gain quantitative insights into your decision, further underscoring the importance of the time value of money.

Last Updated: June 23, 2023

Time Value of Money Video Explanation

Roman Zelvenschi

I started a digital marketing agency Romanz Media Group Inc. 12 years ago. Running my own business quickly taught me the importance of cash flow. Making sales was not enough, I had to have money in the bank to pay the vendors, staff and personal bills.

During those early stages of the company I learned how to get creative with debt and to save on interest cost. I paid for everything I could with a credit card to both get more points and to extend the payment date by 25 days (credit card grace period). I then utilized a 0% balance transfer offers to rotate this debt.

I learned a lot during this process and made a lot of mistakes. My key lesson is that the most important part of being financially independent is how much I managed to save, rather than how much I earned. Staying disciplined with savings and tracking spending is not easy and I tried many different methods to stay on track.

FinancialFreedom.Guru is a side project where I and my staff are trying to share the practical knowledge on how to understand finances and to build wealth.

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Jeremy Pargo
Jeremy Pargo
3 years ago

Hi there,
How to calculate future value in excel?

Ekaterina Redko
Admin
3 years ago
Reply to  Jeremy Pargo

To calculate the Future Value in Excel, go to the Formulas tab in Excel and select “Financial”. In the sub-menu, choose “FV”. You will need to specify the following values:
• “rate” is the interest rate,
• “nper” is the number of payment periods,
• “pmt” is the payment per period,
• “pv” is the present value (if not specified, = 0)
• “type” shows when the payment is due – at the beginning of the month (the value is “1”), or at the end of the month (the value is “0”).
Insert the right numbers and click “OK.”

Ian
Ian
3 years ago

Time value of money really matters. A long time ago I had a friend who taught me to always have a hundred dollars tucked away. She called it walking around money. I still believe in this simple system to never using a credit card. That’s my philosophy

St.Serfes
St.Serfes
3 years ago

Can’t but agree with you. I try to persuade my wife that when she keeps the money in her saving accounts, she is actually losing, on average, 3% per year

Vic
Vic
3 years ago

Thank you for the bright explanation. My conclusion – the only thing you’ll never get back is time so invest as early as possible )

Justin
Justin
3 years ago

Good article. I really do appreciate your posts, they help to teach a number of random people on the internet on how to finance their money. Thank you 

Alisher
Alisher
3 years ago

It’s exactly the case when the sooner the better. The sooner you start investing your money the better it is for you, I mean the sooner the compound effect happens, minus 2 % inflation each year

Kurt
Kurt
3 years ago

The best thing about investing is that it is beneficial for you due to compound interest as the time pass

Jason G
Jason G
3 years ago

It is the most basic and important concept that each person must be taught- but not everyone cares

Selani
Selani
3 years ago

Nice summary. This stuff can become complicated once you factor in many cash inflows and outflows at various periods

Hilda
Hilda
3 years ago

Time is money, and nowadays it is quite rare that one has them both at the same time

Joe Mint
Joe Mint
3 years ago

This is a good explanation of the concept. The key moments are what rate you can earn on the money plus what level of risk you have to put the money at to earn that rate