Understanding the Time Value of Money Concept

Time Value of Money
Time and money are resources we consider really important. We know this because both of them are limited. And so having a certain amount of money now is not the same as having that same amount at a later time. Imagine, for instance, owning a million dollars now versus possessing it a year from now. Owning that amount now will give us the opportunity to invest it and make it grow which means by the time a year passes we probably would have more than the initial million we got. Contrast that if we were to have a million dollars a year from now, we would not have that same opportunity to invest it within the year that we will be waiting for it.

The Cost of Borrowing
This illustration, hopefully, gives us an idea why we have a concept called time value of money. This is the reason why lenders charge borrowers with interest. An interest is a fee paid by a borrower to the owner of the money as a form of compensation for the use of that amount.  This fee is always a percentage of the amount borrowed over a certain period of time which is termed the “interest rate”. An example of an interest rate would be 10% in a year. This means that if we borrowed money, we would have to pay an additional 10% of the amount that we borrowed when we return the money a year later.

Investing Our Money
That same concept would apply to investing our money. This is just like us being the lender instead of being the borrower. Since we “lent” money for others to use we would obviously receive payment for that service with an amount dependent on the prevailing interest rate. That interest payment that we receive can also be used as additional investment itself. When this happens, the interest payment will also earn a fee. This event is what we often call compounding interest. When the interest of our investment earns interest as well, our investment is said to have a compound interest. Obviously as time passes, the interest earnings that the investment receives will be increasing.

Assuming we invested 100 dollars which earns 10% interest compounded yearly, on the first year that investment will increase to 110 dollars with the initial investment plus the interest earned. But on the second year the same investment would now become 110 dollars plus 110 times 10% which makes it a total of 110 plus 11 equals a total of 121 dollars. As we can see, 11 dollars are added on the second year as against only 10 dollars the first year. Every year that passes will add more and more to the investment which makes the interest payment increasing as well.

The Time Value of Money Concept
Because of this concept of the time value of money, we would be able to compute how the value of a given investment will change if we knew the interest rate and the amount of time being considered. This computation involves some formulas that are easy enough to understand. I will be posting more articles to explain this in a very simple manner as time goes on. Knowing these things will help us to analyze if a given investment opportunity which will earn an interest of a certain amount will help us achieve our financial goal or not. These basic concepts will serve as stepping stones in our journey to become financially healthy.