“Although the “time value” of money is a somewhat intuitive idea, many people fail to take it into account when planning their retirements.”- Joe Uppleger.
The time value of money or TVM is an essential money principle that says that the current value of any sum of money is worth more than the future value of that same amount.
The time value of money comes from idea that there are so-called opportunity costs that you must consider when choosing to access cash now or take future payments.
For instance, let’s say your great-Aunt Sally left you a sum of $250,000 in her will. According to the will, you can take the entire $250,000 at once or opt to get the money in equal payouts over five years. Aunt Sally sweetened the pot by including a $25,000 bonus payment if you choose to wait five years.
The instinctive choice most people make is to take the lump sum now and not wait years in the hope of getting more. By accessing your money right away, you could potentially invest it and earn far more than the bonus you’ll get by waiting. You could also use the funds to pay off high-interest debt, which positively affects your credit, pay down your mortgage, buy a cash-flowing business, or lock in value with an annuity or other safe money product.
How to calculate the time value of your money
If you don’t mind spending some time in the weeds, you can use math to help you decide whether to make a payment now or later. There are five variables typically used to determine the time value of money.
- Depending on the calculation you make, you will use the annual discount rate or the interest rate.
- Payments, if any
- The future value. Future value is the dollar amount you may receive in the future if you wait.
- Present value. Present value is the amount of cash you have on hand right now.
- The periods involved (months, days, or years)
If you’re a math nerd and like to do calculations by hand versus using a financial calculator. For example, the future value formula looks like this:
And for present value, it is
Don’t forget to include inflation
Inflation and its’ attendant loss of purchasing power are some of the most significant erosive factors when it comes to your money. Inflation constantly eats away at your savings and can seriously impact your quality of life in retirement. That’s why it is so crucial to include inflation, along with the rate of return you may get from waiting when deciding whether to take a lump sum now or later.
Summing it up:
Time impacts all of us in many ways. It definitely affects our money, and we must consider this if we want to avoid making mistakes now and when we retire. That’s why it’s critical to meet with your advisor and have them explain the time value of money and how you can use this concept to make better money decisions.