Understanding the Time Value of Money
We know, from the concept of Time Value of Money
, money received today is much more valuable than the same amount received at a future date. So if you start early enough, time can be a big ace up your sleeve in achieving your financial goals.
The concept of time value of money comes into play in almost every decision or calculation in financial planning or investments that you make. We are always looking at or comparing money at different periods, be it buying a car and paying a loan in 5 years or investing in a bond or a fixed deposit and looking at the interest rate earnings. Most importantly, it helps us determine how much to save to reach a specific financial goal.
The concept of time value of money has two important components: Future Value and Present Value. Future value is used to find out what an amount invested today will grow into in the future. Present Value, on the other hand, determines what the final amount or cash flow to be received in future is worth in today’s value or present time.
Future Value and Compound Interest
So how does the time value of money makes your small investments grow into large sums over time? It happens through compound interest. Compound interest essentially keeps adding interest on previous earned interest, making your investments grow exponentially. Naturally, interest rate also plays a key role along with the time factor in compounding. A small change in interest rates can have a big impact on future values.
Till now, we have looked at investments in the current date and their value at some point in the future. What if we want to find out, how much the future value will be equal to in the present time? For example, say you were told that you would need ₹2.5 crore to live comfortably after retirement whilst maintaining the same standard of living as today. It may sound like a huge amount of money today, but will it be enough, say 30 years from now? If you could get an idea on what this ₹2.5 crore is worth in today’s value, it would give you a clearer idea on how much you need to save and invest. In finding the present value, what we are doing is bringing the money back, from the future, to the present.
This is essentially inverse compounding. In inverse compounding, we work with the discount rate, which is the interest rate used to adjust or ‘discount’ the amount to bring the amount from the future to the present.
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