Tick, tock, tick, tock! Time flies when you’re having fun, but did you know that time can also make your money grow? That’s right! Welcome to the exciting world of the time value of money, where we’ll explore how time, risk, inflation, and opportunity costs play a significant role in shaping our financial future. So, grab a coffee and let’s explore the basics of this monetary phenomenon.
As Suze Orman said: “Don’t underestimate the power of compounding. It’s the secret sauce that makes the time value of money so magical.”
The Basics of The Time Value of Money
Before we dive into the nitty-gritty, let’s understand the basics. The time value of money is a fundamental principle in finance that states that money available today is worth more than the same amount in the future. But why is that? Well, it’s because of three essential factors: risk, inflation, and opportunity costs.
Let’s take a closer look at each of these aspects and discover if time is your financial friend or foe.
Risk: The Leap of Faith
Risk encapsulates the uncertainty of the future. By having money today, you avoid the risk of not receiving it in the future. There are plenty of investment options in this world, each with a different risk level. To compensate for this risk, you may demand an extra sum, called interest, to be added to the loan. This interest rewards you for taking on risk and provides a buffer for potential losses.
In the world of investments, the higher the risk, the greater the potential return you may demand to take on that risk.
Your investment risk level should be aligned with your goals, but to get the balance from the time value of money you shouldn’t take on so much risk that you lose your capital or too little risk that you don’t achieve your investment goals. Remember, it’s all about balancing the risk and the reward to increase your wealth!
Inflation: The Sneaky Thief
Ah, inflation! It’s the thief that erodes the purchasing power of money over time. Picture yourself walking into a Pick ’n Pay with R100 in your pocket. You find your favourite chocolate bar priced at R15, but when you return a year later, the same chocolate bar now costs R17. What happened? Inflation stole some of the value of your money!
Inflation is the general increase in prices over time. It means that the same amount of money will buy you fewer goods and services in the future. To protect your wealth from the ravages of inflation, you need your money to grow at a rate higher than the inflation rate. This is where investing comes into play, helping your money keep pace with – or even surpass – inflation.
Inflation, or the loss of purchasing power, also brings with it the illusion of wealth. Many topics around the braai would be about a house being sold for R2m when it was bought for R800 000 a few years back. Keep in mind that if the growth did not keep pace with inflation, the storyteller did not make any money at all.
Opportunity Costs: The Dilemma of Choices
Opportunity knocks, but only once! The concept of opportunity costs reminds us that by choosing one course of action, we sacrifice the potential benefits we could have gained from making a different choice. Let’s say you have R50 000, and you’re contemplating investing it in the stock market. However, you can also spend it on vacation in a tropical paradise.
If you decide to invest in the stock market, the opportunity cost is the loss of the experiences, memories, and relaxation you would have enjoyed on that vacation. On the other hand, if you choose the vacation, the opportunity cost becomes the potential gains you could have earned from your investment. It’s all about weighing the pros and cons and making decisions that align with your goals and priorities.
Delaying when you start investing is also an opportunity cost, as money can only grow by investing. The sooner you start investing, the more you’ll be rewarded.
Basic Math of The Time Value of Money
The basics of the time value of money have five inputs. You will generally have four of these inputs and are looking for the fifth.
These five inputs are:
- PMT(Payment) – Are you making a payment towards something?
- I(Interest rate) – What is the interest rate?
- N(Time) – What is the timeframe?
- PV(Present value) – What is the present value of the payment?
- FV(Future value) – What is the future value of the payment?
Example 1: Saving for a Vacation
Let’s say you want to go on a dream vacation in two years, and you estimate that you will need R50 000 (FV) for the trip. You decide to start saving money monthly in a savings account with an annual interest rate of 9%. The monthly payment (PMT) you can afford to set aside for savings is R3 000. Now, you want to determine the future value (FV) of your savings in two years.
Inputs:
PMT (Payment) = R3000 pm
I (Interest rate) = 9% (expressed as a decimal, 0.09)
N (Time) = 2 years, but use 24 months (N needs to align with your payment. If monthly, use months here.)
PV (Present value) = R0 (assuming you haven’t started saving yet)
To find FV (Future value), you can use a financial calculator or a spreadsheet function. In this case, the future value of your savings after two years would be approximately R78 565.41. It looks like you’re going on holiday!
Example 2: Calculating Loan Repayment
Let’s say you want to borrow R50 000 from a bank. The loan carries an annual interest rate of 11%, and you want to determine how much you should repay monthly to repay the loan in three years.
Inputs:
FV (Future Value) = 0 (You want the loan balance to be 0 in three years)
I (Interest rate) = 11% (expressed as a decimal, 0.11)
N (Time) = 3 years or 36 months (N needs to align with your payment. If monthly, use months here.)
PV (Present value = R50 000
To find PMT (Payment), hit the PMT button after inserting the other inputs, and you’ll see the monthly payment required to repay the loan in three years at 11% is R1 636.94 a month.
What Can You Use Time Value of Money for
As you can see, there are plenty of uses for the time value of money, ranging from personal finance, retirement planning, investment planning, and many more. For now, just do some examples and ensure you understand the basics of the time value of money.
Summary
And there you have it; the time value of money demystified! By understanding the role of risk, inflation, and opportunity costs, you can make smarter financial decisions and take steps toward securing your financial future. Remember, time is your greatest ally or your worst enemy. It’s up to you to decide!
