What is the Time Value of Money?
The time value of money (TVM) states that money available now is worth more than the same amount in the future because it can be invested to earn returns. $1,000 today invested at 7% becomes $1,967 in 10 years. Conversely, $1,000 promised in 10 years is worth only about $508 today at a 7% discount rate. This concept underlies all of finance.
Applications of TVM
TVM is used to evaluate loans, compare investment opportunities, and plan for retirement. A mortgage payment schedule, the pricing of bonds, and the valuation of companies all rely on TVM calculations. When choosing between receiving $10,000 now or $12,000 in two years, TVM helps determine which option is financially superior given current interest rates.
Key Considerations
The discount rate used in TVM calculations dramatically affects the result. A higher discount rate makes future cash flows worth less today. Inflation, opportunity cost, and risk all factor into choosing the appropriate discount rate. For personal financial planning, using a rate of 5-7% (reflecting long-term stock market returns minus inflation) is a reasonable starting point.