Inflation has been top of mind for all of us. Supply chain constraints and economic policy changes in 2022 and 2023 have impacted the cost of just about everything, from grocery essentials all the way up to real estate. This may have caused you to think about a financial concept you may not realize has a name: the Time Value of Money (TVM). Understanding TVM is important so you can make informed choices about saving, investing, borrowing, and planning for your financial future.
In this post, we’ll cover the concept of TVM, so you can understand its significance and be on the lookout for when it may apply to purchase decisions you will make.
Please note: this is for educational purposes only. This is not investing advice.
What is the Time Value of Money?
Let’s start with the definition. Investopedia defines it as, “a financial concept that holds that the value of a dollar today is worth more than the value of a dollar in the future. This is true because money you have now can be invested for a financial return; also, the impact of inflation will reduce the future value of the same amount of money.”
Like a lot of financial concepts, there is some math involved. TVM is expressed as an equation, with variables including the Present Value of the sum of money, the Future Value of the sum, the interest rate (such as Annual Percentage Yield on a savings account), and the number of compounding periods – which represent the time intervals between interest accruals. Future Value represents the value of an investment at a future point in time. Present Value is the inverse and represents the value today of a future amount of money.
Here, we’re focusing on the higher level concept of the time value of money, and we don’t need to be accountants to grasp that, so we’ll sidestep the algebra breakdown. If you do want to calculate it for a specific consideration, we highly recommend using an online Time Value of Money calculator to do the calculations for whichever aspect you’re solving for.
Why Money’s Value Changes Over Time
Why is there a time value to money at all? There are two main reasons why money’s value changes: inflation and the potential of investing.
Inflation can happen gradually as the result of our economy growing. As people have more money (perhaps due to increased wages, or good stock market performance), their demand for goods and services goes up. Prices rise in response to even out the demand. Other workers will eventually need more money to keep up with the rising cost of goods, and employers will respond by paying higher wages.
In the real world, this cycle is not uniform. Inflation happens at different paces in different areas of the economy or in different geographic regions that trade with one another. It can happen suddenly in response to supply shortages or surpluses due to things like changing technology, natural disasters impacting raw materials, or regulation changes. This is part of what sparked the inflation we have experienced in the last few years – rapid supply drops due to the pandemic backing up manufacturing and logistics. The lack of uniformity propels inflation.
However, the other aspect of TVM that expands it beyond inflation is that $1 is worth more today than in the future because of the power of investing. You could take any sum of money and invest it and it would (in general) grow over time – either through the value of the product or potentially interest payments along the way. This applies to financial products like a high yield savings account or Certificate of Deposit where you earn interest on your money. It could also apply to owning a stock that pays dividends, or owning a rental property where you get rent payments from tenants. U.S Treasury securities are a common example to illustrate this concept because they are backed by the full faith and credit of the U.S. government. Unlike a stock or an asset that could lose value and thus mess with the equation’s calculations, the Treasury will pay out the promised return.
The Impacts of Time Value of Money on Financial-Decision Making
How does the Time Value of Money impact you beyond the rising prices of goods? It can impact your decision-making process around finances, whether it’s buying or investing. Most commonly, it can motivate you to start or keep investing, because it’s important to grow your money so you can keep up with rising costs – especially when it comes to retirement when you don’t have wages coming in.
When making investment decisions, you could use the TVM to calculate the future value of a sum of money to evaluate which option will have the highest yield. This works well as a guideline, but the equations don’t factor in things like tax implications or changing market forces, plus your personal financial situation. When you make financial decisions, you’ll want to balance those real-world considerations!
Another impact that TVM has involves timing of key purchase decisions. You can’t predict the future, but you know that in general, things will become more expensive in the future. If you have a big purchase decision coming up, the TVM might impact your timeline. Let’s say you have a windfall of $30,000 (after tax) and decide to use the money to renovate your kitchen. You’re trying to decide if you should renovate now or wait one year. Following the concept of TVM, you can reasonably infer that the same type of renovation project – same materials, appliances, construction company – will cost more next year than if you took it on today. However, that $30,000 of cash could grow into more money with investing. For example, if you put all of the money into a stock that grew 10% in a year (after tax), then sold that stock, you could have a renovation budget of $33,000. If that year’s inflation rate is the typical 2-3% each year, the same kitchen project cost would be around $31,000. You would be $2,000 ahead in that scenario.
It may sound counterintuitive, because saving up for purchases is widely recommended as sound financial advice! However, at times it’s more cost-effective to buy something sooner before the price potentially goes up. For example, real estate prices and home values have climbed dramatically the past few years. The median home price for an existing home in the US in Q1 2021 was $313,500. If you were considering buying but decided to wait to save up for another year, then decided to house shop in Q2 2022, you’d be looking at a median home price of $405,900 – a 29.47% jump. Since it’s unlikely you could have grown your money at a commensurate rate, the concept of TVM would indicate that it would have been a smarter move to buy whatever home was within your price point at Q1 2021. (Admittedly, that is a larger than usual increase, but a real-world example to illustrate the point.)
The most important takeaway is that if you do nothing with your money, it will become less valuable over time. Every day, month, or year that you wait to take advantage of ways to grow your money you are missing out on growth via compound interest. That’s why it’s so important to start using a high yield savings account if you aren’t already!
Opportunity Cost and the Time Value of Money
Opportunity cost is a different economic concept that plays a significant role in financial decisions and is relevant when considering the time value of money. Opportunity cost refers to the value of the next best alternative that you give up when you make a decision. This concept is important because resources like time and money are limited. The opportunity cost of something can be a dollar amount, a purchase, or it can be a use of your time.
Whenever you are pondering an important financial decision, you should consider what the trade-off is by choosing that option. For investment decisions, as you calculate the potential return on investment, you should also consider what else you could do with that money if you didn’t invest it. Sometimes, based on the TVM, that might prompt you to buy something to lock it in at a lower price.
This also applies when you borrow money. When you take out a loan with interest, you’re not just paying back the amount you borrowed; you’re also paying interest. This interest represents the opportunity cost of using borrowed funds. If you pay $3,000 in interest over the life of a car loan, that money has an opportunity cost of what it could grow into instead – potentially tens of thousands of dollars over the years.
Ultimately, opportunity cost and the time value of money are names for concepts that come into play as you make financial decisions. They can help you stick to the course of making strong financial decisions that benefit you in the long run even if it means compromising on something in the short term. However, there are plenty of real-world factors to consider beyond just these two financial concepts. If your car is broken and you need it to get to work, you’re not going to weigh the opportunity cost of repairing it or not! The key point is to take time to consider the best uses for your money when you have the ability to be strategic and intentional.
Conclusion
As you consider future financial decisions, you now can see how the Time Value of Money can guide you when making choices and evaluating trade-offs and compromises. It’s important to recognize the delicate balance between meeting your needs with the financial resources you have on hand, like cash or strategic borrowing, and securing long-term financial well-being given factors like inflation. These concepts are an important part of building your financial literacy so you can feel empowered when making money moves!
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