Now that you hopefully have a clear understanding of interest and investing, let’s discuss the time value of money, an important financial concept.
The time value of money says money now is better than money later. This is a bit vague, so here's an example. According to the time value of money, it'd be better to receive $10,000 today, than $10,000 in 5 years. This is because cash in hand has the possibility of generating additional money over time. This profit can be generated by investing in the financial markets, funding a business, or even by receiving interest on idle money. Essentially, any action that will increase your initial investment.
The time value of money is supported by historical data.
Let’s use the example from the previous section. Say you win a local lottery, offering $10,000 in cash today, or $10,000 in 5 years. Before you continue, think about which option you would choose.
By investing in, say, the S&P 500, a collection of 500 large US companies, on average, you will receive 7-10% per year in the long term. So, if you receive a payment of $10,000 today, and invest it into the S&P 500, historically speaking, in 5 years, you will receive anywhere from 40-60% returns. So, with the power of compound interest, your initial $10,000 can turn into $14,000-16,000.
So, if you plan on investing any cash you receive, you can logically assume that $10,000 today would equal around $14,000-16,000 in 5 years. This means that for you to choose the second option of delayed payment, you would have to be receiving at least $14,000, as that would be equivalent to the money you would have (presumably) if you chose the first option of instant payout.
Like I stated earlier, this doesn’t only apply to investing. It applies to anything that you can purchase/fund that will generate profit over time.
While the time value of money is mostly considered when looking at interest-generating assets, receiving profit from investments is not the only way to benefit from money sooner rather than later.
For example, if you have a large amount of high-interest debt, like credit card debt, receiving a large amount of money that can pay off that debt can be very beneficial. It’ll save you money in the long term as you won’t have to pay a ridiculous amount of interest and it’ll improve your credit.
It's important to note that this doesn't account for a bunch of different factors. What if the item you invest in doesn't do well? The financial markets don’t return 10% every year, and years can go by without profit. Businesses can fail, turning your initial investment into nothing. What if you’re unable to invest the money because you need to spend it on bills/expenses?
The time value of money is only a guiding principle. Tailor it to your situation, making sure you account for your specific circumstances.
To sum it all up, the time value of money describes the concept that having money now is better than having the same amount of money in the future. By having money in hand, you can use the cash to generate profit/income. This can be done by investing in the financial markets, funding a business, or even letting it acquire interest in a savings account.