Time value of money

Before you rely on it

What to check

Bring amounts to a common date before comparing them.

The common error

Where people go wrong with time value of money

Comparing a payout now against a larger payout in five years by looking at the two numbers. Without discounting, no comparison has happened.

Worked through

Time value of money in plain numbers

One thousand dollars today can be invested. At 5% it becomes $1,050 in a year, so getting $1,000 in a year is worth less than getting it now. Run it forward or back. $1,000 today grows to $1,628.89 in ten years. And $1,000 received in ten years is worth only $613.91 today, since $613.91 invested at 5% would grow to $1,000. Which do you prefer: $900 now or $1,000 in a year? At 5% the $900 grows to $945, so you would take the $1,000. At 12% the $900 becomes $1,008, so you would take the cash, and the choice depends on what the money can earn.

Easily confused

Time value of money and its neighbours

The time value of money is the principle behind present value, future value, discounting and compounding; it is not inflation, although inflation is one reason money now is worth more. Others are opportunity to earn interest and risk that a future payment does not arrive, and it differs from net present value, which applies the principle to a specific project. The principle is the reason lenders charge interest and savers earn it. It holds even when prices are stable.

In real decisions

Where time value of money turns up

Loan payments, mortgage calculations, retirement planning, lease-versus-buy comparisons, settlement offers and business investment decisions all depend on it. Financial calculators and spreadsheets have functions for present value, future value, payments and rates; anyone who compares a lump sum with a stream of payments is applying it; it underlies the discount rate and the required return.

Know the edges

Where time value of money stops being reliable

The answer depends on the rate you assume, and the right rate is uncertain. Real rates change, and payments may not arrive on time. Taxes and fees alter results. The principle says nothing about preferences or needs, such as liquidity, and use scenarios to see how sensitive a decision is to the rate.

Quick answers

What people ask about time value of money

How do I compare money at different dates? Convert each amount to a common date, usually today, using a discount rate, then compare the present values.

Does the time value of money apply when there is no inflation? Yes. Money available now can earn a return and is more certain than a promise of later payment.

What is the link with interest? Interest is the price of using money over time. It is the reason present and future amounts differ.

What is the discount factor? One divided by one plus the rate, raised to the number of periods. Multiply a future amount by it to get present value.