Time Value of Money in Decision Making
posted in calculations, finance |A bird in your hand is worth two in the bush - do you understand that metaphor?
Essentially, it’s saying having something in your hands today is worth more than having it down the road - but we aren’t talking about that new car, television, or hot new gadget. We’re talking about cold, hard, cash. It makes sense, right? A dollar in your hands for your expense or savings make more sense than a dollar down the road - where that dollar isn’t giving interest or reducing debt (and the interest you owe).
To show the TVOM we have two useful questions:
- What will an investment be worth after a period of time? This is the future value.
- How much must be put away today to provide some dollar amount in the future? This is present value
These calculations are based on basic interest principles: The dollar amount, the rate of interest earned, and the amount of time the money is invested. One formula is the simple interest formula. We break it down as:
- i = prt where
- p = the principal set aside
- r = the rate of interest
- t = the time in years that the funds are left on deposit.
For Example:
If someone invested $1000 (like in an ING CD - contact me for a referral and $25!) for four years with 5.35% interest, they’d receive $214 in interest over the four years. This simple interest formula assumes that every year we withdraw the interest and only keep the $1000 invested. As a savvy investor (or saver!) we don’t really want to do this if we don’t want to. What we want to do is use compound interest. Gain interest on your interest.
If we take our original $1000 and think of the compound interest:
At the end of our first year - our $1000 will grow to $1053.50 [$1000 + ($1000 * 0.0535)].
At the end of our second year - our $1053.50 will grow to $1109.86 [$1053.5 + ($1053.5 * 0.0535)].
At the end of our third year - our $1109.86 will grow to $1169.24 [$1109.86 + ($1109.86 * 0.0535)].
At the end of our fourth year - our $1169.24 will grow to $1231.79 [$1169.24 + ($1169.24 * 0.0535)].
So compoinding means we gain an extra $17.79 in interest. Doesn’t seem like much, does it? But when we increase the interest (such as, the average return on your investment portfolio, or your 401k) the amount increases more - and the larger the balance, the more interest generated, and the more money you end up with!
