Understanding the Time Value of Money and Its Importance

“I can turn a small fortune today into a great wealth tomorrow, yet I can also make tomorrow's treasure worth less than it seems today. I am the reason why a rupee in your hand now is more valuable than the promise of a rupee later. What am I?”

We are referring to the Time Value of Money (TVM). Understanding TVM is vital for making sensible financial choices for the future. Here is a brief guide that explains time value of money’s importance and how it can help you make a future-proof financial plan.

What is the Time Value of Money

The Time Value of Money concept is based on the idea that money with a certain value today will have a different value (usually lower) sometime in the future. You can put it this way: your money today has more buying capacity than the same amount will have after a certain period of time.

If you think about it practically, ₹1,000 invested at an annual interest rate of 5% will yield ₹1,050 in one year. So, if you have a choice to get ₹1,000 today, or one year from now, you should take it today. The simple reason is that you can invest that money and increase its value over the year.

It is important to recognize the time value of money. Start investing smartly before inflation catches up and erodes the value of your savings.

What are the Major Components of Time Value of Money?

The four primary components of TVM are:

Present Value: The current day value of your saved money.

Future Value: The purchasing power value of your money after some time has passed. The purchasing power of your money will either depreciate or appreciate based on the rate of interest that it is subject to.

Time Period: The value of money changes over time. When calculating the time value of money, the time period taken into consideration is extremely important.

Rate of Interest: All money appreciates or depreciates at a rate of interest. This rate could be your bank’s general interest rate, the market growth rate of your investments, or the inflation rate that slowly reduces the purchasing power of your money year-on-year.

Time Value of Money Formula

The formula to determine the future value (FV) of a present sum (PV) is:

FV = PV x [ 1 + (i / n) ] (n x t)

Here’s what each term means:

FV = Future Value of money

PV = Present Value of money

i = Interest rate

n = Number of compounding periods per year

t = Number of years

How to Calculate the Time Value of Money

Let's say you have ₹10,000 and you invest it for 5 years at an annual interest rate of 8%, compounded quarterly.

So,

PV = ₹10,000

i = 8% or 0.08

n = 4 (since interest is compounded quarterly)

t = 5 years

FV= 10,000 x [ 1 + (0.08 / 4)] (4 x 5)

FV= 10,000 x 1.485947

FV= ₹14,859.47

So, if you invest ₹10,000 at an 8% annual interest rate compounded quarterly, the future value in 5 years will be approximately ₹14,859.47. But will this be enough to beat inflation? That is why you need to safeguard your financial future by making strategic investments and revamping your financial plans.

Planning for TVM with a Savings-Linked Life Insurance Plan

Life insurance plans with a savings element can act as a buffer against inflation. Let’s take Edelweiss Life- Wealth Plus as an Example. This plan not only provides life cover to your family in case of your death, but also invests your paid premiums into market-linked funds that grow over time as per market interest rates.

Say you invest ₹10,000 per month for a period of 10 years. Assuming that your market-linked funds grow at a rate of 8% p.a. (it can be lower or higher! Market rates are never fixed) we can calculate your future returns:

Total Premium Paid = ₹12,00,000

Total Returns After 10 Years (@8% p.a.) = ₹16,75,037

Total profits = ₹4,75,037

This means that by saving your money in a ULIP, you can grow its value during that time period and keep up with the rising inflation rates. Doing so ensures that your money does not lose value over time.

Why is Time Value of Money Important for You?

It is essential to understand the time value of money for several reasons. Some of them are given below.

• Investment Decisions: If you understand TVM, then you can consider whether a given investment opportunity should be pursued. You can compare different investments available to you and select the one that maximizes your return on investment.
• Assessment of Loans: Chalking out a proper strategy for quick repayment of loans will help you save more in interest costs.
• Impact of Inflation: Over time, inflation means that the same amount of money can buy less in terms of real goods or services. TVM enables you to understand that you need to save/invest more to maintain your buying power.

How Can You Increase the TVM on Your Investments?

A few strategies to optimize TVM for your investments are listed below:

1) Stay Invested for the Long-Term: Because of the power of compounding, you can earn more from your assets if you stay invested for a long time.

2) Consider Additional Charges: Always take the investment fees into account before buying into any plan. The charges should not negate the returns you get from the investment.

3) Choose EEE Investment Options: An EEE (Exempt-Exempt-Exempt) category investment is the one which has tax exemptions on investment, interest, and maturity value. One example of an EEE investment option is a Unit Linked Insurance Plan (ULIP), which combines investment and insurance into a tax efficient financial product. Choosing such an option allows you to save on taxes and maximize the TVM of your investment.

Conclusion

The time value of money is a fundamental financial concept. Understanding TVM helps you learn how your money can grow over time. Whether you are planning for future goals, considering investment options, or simply keeping a tight rein on your finances, understanding of the principles of TVM can greatly benefit your financial well-being. Apply the principles of TVM, make smarter financial choices, and achieve your goals for the future.

FAQs

How is Time Value of Money used in Finance?

The basic principle of TVM is that today’s money is more valuable than the same amount of money in the future. Hence, this principle is used in various financial decisions such as making smart investment decisions, loan rate calculations, asset assessments, and planning for retirement etc.

What is the TVM Calculator Used for?

A TVM calculator can be used to quickly determine the future value of your current savings. By using a TVM calculator, you can find the ideal interest rate required to maintain your money’s value in the future.

What Impact Does Inflation Have on Time Value of Money? 

Inflation is one of the main driving factors behind the time value of money. Inflation slowly increases the basic costs of various goods and services, and this in turn, increases your basic living expenses and reduces the purchasing power of your savings. Hence, the main crux of TVM is that you need to grow your wealth via investments to match or overcome the current inflation rate. Failing to do so will result in the devaluation of your current savings.

 

Swati Tumar - Travel & Finance Writer

Swati is a Writer in the day and an illustrator at night. Among her interests, she is quite fond of art and all things creative. She often indulges herself in creating doodles, illustrations, and other forms of content. She identifies herself as an avid traveler and shameless foodie.