Successful investors understand the time value of money and use it to their advantage. Even small amounts of money can grow to substantial sums over time. The phrase “time value of money” is often used in conjunction with the word “compounding” or the phrase “compound interest.”
What is the time value of money? It is the value of a dollar at different points of time (e.g., today, 10 years ago, or 10 years into the future). Many financial experts define it this way: “a dollar in the future is worth more than a dollar today.” This is due to the combined effects of compound interest and time. For example if you receive $1,000 today and invest that money in an account earning 5% interest, one year from now it is worth $1,050. If you receive $1,000 a year from now, it does not have the chance to earn that interest. You lose the earning power of compound interest by receiving it at a later date.
The time value of money is important in many ways. It helps people map out personal financial plans by determining what their money will be worth in the future. When it comes to savings there are two things working for you: time and interest. To illustrate the time value of money concept, answer the following question that was posed to students by Iowa State University’s Financial Counseling clinic. Who will make the most money for retirement at age 66 assuming a long-term average annual return of 10%: Person A or Person B?
Person A: A 22-year old who saves $2,000 a year until age 26 ($10,000 total investment)
Person B: Someone who starts saving at 32 and saves $2,000 a year until retirement ($70,000 total investment)
The correct answer is Person A. This may seem counter-intuitive, considering Person A’s $10,000 investment versus Person B’s $70,000, but it proves a vital point. The earlier you start saving, the harder your savings will work for you through additional years of compound interest. Person A will end up with a grand total of $607,887 whereas Person B will have $596,254 with a lot more money out-of-pocket invested.
If we consider the same scenario, starting to save $2,000 a year with 10% interest at 22, but doing so every year until 66, the total will come to a whopping $1,581,591. Alternatively if you are not a big risk taker and prefer to invest at a lower interest rate, you will have to save more money to get the same amount as someone earning a higher interest rate. Say you still invest $2,000 a year until age 66 but earn 6% interest. The amount you will end up with at retirement is will be $611,504. To accumulate $1,581,591, you will have to save $5,173 a year.
Compound interest plays a vital role, along with time, to make investments grow. It is what drives the time value of money. When you are earning interest each year, you are earning it on both the initial investment and interest earned in the past. In other words, you are earning interest on top of interest.
Time is also very important to have on your side when saving for the future. Even if you only put away $240 a year (that’s only $20 a month!) from age 22 to age 66 earning a modest 4% return, you will earn $30,209. If you waited another 20 years to start investing that same amount with the same interest rate, you would only have $10,395. This reinforces the point that time is one of the most important financial tools that investors can have.
The time value of money can also work against you. If you take out a loan or use a credit card to purchase something and revolve a balance, you will owe interest. Over time, the cost of interest can be significant, especially on debts that have a long pay-off period (e.g., mortgages) or when making only the required minimum payment on credit cards (e.g., it takes 17 years to repay $6,000 by making minimum payments).
If you plan for it, the time value of money can work hard for you to generate a large amount of savings over time. Remember that money invested today is much better than money invested in the future. That’s because compound interest is not retroactive. If it seems like a stretch to start investing now, remember that putting away even a little bit of money now is better than postponing this until some future date, You know the old saying “time is money”? With compound interest on savings, you have the time value of money on your side.
