One concept every business school across the country teaches is the concept of time value of money. This concept is basic in nature despite some comprehension difficulties many face. Once mastered, time value of money is a powerful tool used by millionaires and aspiring financial freest alike. As it relates to investments, time value of money can be summed up in two words: start early.
Suppose you have $100. With this $100, you have three options. You can spend it, you can save it, or you can invest it. Now let’s look at the same $100 five years from today. If you spent it, whatever you bought has been consumed, has no more financial value, and all you have left is the air where that $100 used to be. If you saved it, you would still have that $100 bill. The only difference is that five years from now gas has reached $5 a gallon, it costs $15 to go to the movies, and Redbox is now $2 a night. That means if you spent the $100 today, you could buy a whole lot less than if you had blown it 5 years ago.
Before you go spending your money today in fear of inflation, let’s see what happens if you choose the third option: invest it. To keep this example basic, let’s assume you deposited this $100 in a savings account that earned 5% interest. In reality, I don’t know of any savings accounts that pays 5% interest today, but the concept is what we’re trying to learn here. Like most savings accounts, you will see at the end of every month a deposit made by the bank called “interest payment.” This is the bank paying you to keep your money with them. 5% of $100 is $5. You will have 1/12 of this $5, or $0.42, deposited every month. This means by this time next month, you have $100.42
The good thing about time value of money is that you will now earn interest on this new 42 cents. In our example, this equates to an additional $0.02 a year just on last month’s interest. This is an additional 25 cents a year on the $5 of interest. I know what we’re talking about seems small, but every penny adds up.
If you had simple interest, your $100 would make $5 a year for 5 years. Therefore, you would have $125.00 at the end of 5 years. In our savings account example, with time value of money, your interest would accrue interest, meaning your $100 would turn into $128.34. This is because every month your balance increases with interest and the bank pays interest on interest.
Many find it difficult to comprehend how $100 turns into $128.34 instead of $125 and if you still find it a struggle to understand this principle reread this article and try to walk through the math month by month. See the first seven months broken down below:
Month 1: $100 + $0.42 interest (100 x 5% ÷ 12 months = $0.4167)
Month 2: $100.42 + $0.42 interest (100.42 x 5% ÷ 12 months = $0.4184)
Month 3: $100.84 + $0.42 interest (100.84 x 5% ÷ 12 months = $0.4202)
Month 4: $101.26 + $0.42 interest (101.26 x 5% ÷ 12 months = $0.4219)
Month 5: $101.68 + $0.42 interest (101.68 x 5% ÷ 12 months = $0.4237)
Month 6: $102.10 + $0.43 interest (102.10 x 5% ÷ 12 months = $0.4254)
Month 7: $102.53 + $0.43 interest (102.53 x 5% ÷ 12 months = $0.4272)
As you can see, the amount of interest you make each month grows and grows over time even at the same interest rate since you earn interest on interest earned. Back to our example, $100 today can mean $0, $100, or $128.34 five years from now. To fully illustrate the “start early” philosophy, let’s look at that $100 over 30 years.
Option 1: Spend it. Value in 30 years $0
Option 2: Save it. Value in 30 years (a deflated) $100
Option 3: Invest it. Value in 30 years $446.77
Now for fun, let’s say you deposited $100 a month into your savings account. All else being equal, let’s see what you would have after 30 years:
Option 1: Spend it. Value in 30 years $0
Option 2: Save it. Value in 30 years $36,000 ($100 x 12 months x 30 years)
Option 3: Invest it. Value in 30 years $83,672.64
That’s right! Just $100 a month into the bank and the bank pays you $47,672.64 on top of your principal payments.
And there you have it, time value of money at its finest!