Time Value - Money
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Time Value - Money
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Understanding the Time Value of Money By Marguerite McPherson
Have you ever wondered how much money you could be making by simply letting it sit in an account at the bank? Or have you ever thought of how long it will take for your money to be at the right amount you need? The time value of money can answer all these question and more. The time value of money is one of the most important concepts to understand when dealing with finances. The basic idea behind the time value of money is: money has different values depending on when it is received. To simply explain this idea let’s use the example of 1,000 dollars. Would you rather have $1,000 today or would you rather wait and receive $1,000 years from now? We all know the answer to this question. Even though you don’t need the money right away you would rather have the $1,000 as soon as possible, this is true for three reasons. The first is that, as stated above, money has different values depending on when it is received. If you receive the money now, you know how much it is worth, whereas if you received it a year from now you have only a guess of how much it will be worth, due to inflation. The second is, with that $1,000 you could invest and generate some sort of interest during the time that you would have otherwise been waiting to receive it. The final reason is because that $1,000 may not even be there a year later so you might as well take it when you can get it. To understand the time value of money you must be familiar with a few key terms. First you must know the difference between present value and future value. Present value is exactly that, the amount of money that you have at the present time. The future value is the amount of money that you will have at a given point in the future. You must also know the difference between simple interest and compound interest. Simple interest is interest that is earned only off of the initial amount. For example, if you put $1,000 in an account that earns simple interest of 3% then you would earn $30 dollars every time interest is paid. Compounded interest is interest earned on top of interest. For example, if you had the same $1,000 with a 3% compounded interest you would receive $30 on the first interest payment and that $30 dollars would be reinvested in to your account making the total value $1,030. The next time the 3% interest is pay it is paid on the entire $1,030, which means that you would receive $30.90 that would again be add to your account and the cycle repeats. Almost all savings and other accounts today use compounded interest. Now that there is an understanding of the terminology to support the time value of money it can be put to real use. There are many uses for the time value of money, but explaining all of them would be overwhelming. Only two basic equations will be given. These equations will be explained with examples. The first equation is the foundation for the second; so don’t move on until you are sure you have got it.
FV = PV (1 + i)n
FV = Future Value PV = Present Value i = interest rate n = Number of compounded years
1. For example if you invested $2,000 in a savings account today at 3% interest compounded annually, how much money would you have in 18 years if you never take any money out of the account?
In this case: FV = FV PV = $2,000 i = 3% or .03 n = 10 years
FV = $2,000(1 + .03)10 FV = $2,687.83
This is a good example of a parent saving for a newborn child’s college fund. Don’t get discouraged by how low the FV came out to be because remember this was only compounded once a year where as savings accounts are usually compounded twelve times a year. The equation for multiple compounding periods will be shown later.
FV = PV (1 + i/m)mn
FV = Future Value PV = Present Value i = interest rate n = Number of compounded years m = Number of compounds during one year
FV = $2,000 (1 + .03/12)12*18 FV = $3,429.70
In this case, when compounded monthly as compared to compounding annually, an extra $741.87 was made.
FV = $2,000 (1 + .08/12)12*10 FV = $4,439.28
Just think if that $4,439.28 was put back into a similar 10 year account with 8% interest, the result would be $9,853.61 a perfect gift for a twenty year old college student.
Shown are only a few ways in which time value of money can be used today. Understanding the idea of the time value of money gives a head start to anyone that is interested in bettering themselves by taking control of their finances and their lives, because remember money is one of the most essential part of everyone’s lives. The concept just learned can help families plan for the future and make sure that money problems are not ignored, but acknowledged and mended.
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