The Time Value of Money and Compounding
To begin, let’s define the terms “time value of money” and “compounding.”
Time value of money conveys the concept that having a certain amount of money now is worth more than having a similar sum later on. This is because the money you have today has the potential to earn interest or dividends when invested.
Say that you could either get $100 today or get $100 one year later. If you would prefer receiving the funds today, then you instinctively recognize the time value of money. Why is that? A $100 bill has the same value today as it does one year from now, doesn’t it? Actually, although the bill is the same, you can do much more with the money if you have it now because, over time, you can earn interest on your money.
Compounding is the fundamental ability of an asset (e.g., money) to generate earnings that can then be reinvested to generate further earnings. For instance, if you invest in a mutual fund, you can earn dividends from it. You can, of course, have the profits sent to you by check and spend them. Alternatively, you can ask the mutual fund’s manager to reinvest those earnings in the fund so that you generate even more revenue by compounding your earnings. For an investment that pays interest, the earnings in each time period are calculated after taking into account the previously earned interest—not only the initial sum. That’s the compounding effect!
In basic terms, the time value of money raises these questions:
1. What is the present value of cash that is to be received or paid at later dates?
2. What is the future value of cash that is contributed today?
The time value of money means that investing for a longer period makes the money you have today more valuable.
It makes sense that giving your money a chance to develop and compound will mean that you have more money in the end. However, many people do not comprehend the genuine power behind the time value of money. Too many people believe that leaving their money in investments for twice as long will double the amount of profit. They are wrong because they forget about compound interest.[ 1]
Most importantly, compound interest allows your money to grow more quickly when you invest it for longer, as the earned interest is rolled back into your principal so that those profits can start earning interest as well.
If you put $1,000 in a savings account that pays compound interest at a rate of 6% per year, you will earn $60 at the end of the first year. If you reinvest the $60, your new principal of $1,060 will earn $63.60 in interest during the second year (another $60 on the initial deposit of $1,000, plus $3.60 on the $60 earned during the first year). Thus, by the end of the second year, you will have $1,123.60. Cash that is compounded annually at 8% doubles in value in only nine years. If a 25-year-old person invests $2,000 annually at a rate of 8% per year, his or her retirement fund will increase to more than $425,000 by age 65.[ 2]
So, you see, time literally is money!
[1] “Time Value of Money.” Encyclopedia of Business and Finance, 2nd ed. Encyclopedia.com April 9, 2017
[2] “Time Value of Money.” Encyclopedia of Business and Finance, 2nd ed. Encyclopedia.com April 9, 2017
