All of you have probably heard the term, “time value of money” used at some point in time. If you’re a weekly follower of my blog, you’ve heard this term alluded to in several of my postings. What exactly is the “time value of money”? What does it mean?  Some of the time value of money calculations can look pretty complicated and frustrating if you aren’t familiar with the concept. Let’s break down what time value of money really is and why it’s so important to your financial health.

First of all, simply put, the time-value of money is the concept that receiving a dollar today is worth more than receiving that same dollar next year. Why? Well, by receiving that dollar today, you have the opportunity to invest that dollar and gain the interest that comes with that investment. By the time next year rolls around, you would have your original dollar plus the interest it earned. If you simply received the dollar next year, you would have forgone the interest you could have earned by investing the dollar. Time value of money involves 2 main types of calculations: future value and present value.

You’ve heard me talk about the “magic of Time Valuecompounding” throughout my blogs. The “magic” is really just the time value of money at work. When we talk about investing for the future, we are concerned about the FUTURE value of our money. Simply put, if we have the option of receiving money today versus sometime in the future, we want that money today! Then, we can invest it and watch it grow over time. Here’s an example which demonstrates the importance of investing early so that time is on your side. Say you invest $5,000 into a Roth IRA when you’re 25 and that account earns an average rate of an 8% return.  You don’t invest a penny more. By the time you turn 65, your investment will have grown to $180,000. That’s 36 times your original investment! But, wait until you turn 40 to invest the same $5,000. You still invest into a Roth IRA that earns an average rate of 8% and don’t invest a penny more than your original $5,000. When you turn 65, your investment will be worth less than $40,000. By waiting 15 years, you had to kiss $140,000 goodbye. Time is the “magic dust” that multiplies your investments into amounts you never knew were possible.

When we talk about the present value of money, we are talking about taking a future lump sum and determining its value if it were to be received today. Present value calculations are used to determine whether the money paid today for investments can earn a return and be valuable in the future. Consider this example. Someone is looking to purchase a business that costs $85,000. The buyer estimates that the business will generate $85,000 of income over the next 4 years. Since after 4 years, the amount paid for the business would equal the amount earned by the business, it’s a smart investment, right? Not necessarily. You would have to calculate the present value of the $85,000 in profits. If the present value of the $85,000 was only to be $60,000, and the buyer needed to recoup his or her money after 4 years, purchasing the business would not be a good investment. In order for an investment to be deemed profitable, the present value of the future cash flows must be greater than the original outlay of cash (the purchase price of the business in the case of our example).

If you have questions regarding the time value of money and how it could impact your investments, allow Wealth Builders CPAs & Consultants to help! Our team of financial planners would love to help you determine which investments are best for you and get you started on your investment journey! Call us today for a free consultation!

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McGee, Suzanne. “Millennials Could Be Millionaires, But They Need to Start Investing Now.” The Guardian, 13 Oct. 2016, www.theguardian.com/money/us-money-blog/2016/oct/13/investing-millennial-money-saving-study.

“What is Present Value (PV)?” My Accounting Course, www.myaccoutningcoach.com/accounting-dictionary/present-value.