The time value of money commonly called time value is the concept that money available today (present time) is more valuable than the same amount in the future. It is a core principle of finance which state that if money can earn returns, then it is worth more the sooner it is received.
We can also describe the time value of money simply as : the D100 received today is more valuable than D100 to be received in one-year time.
How is that possible ?
Simple! The D100 received today can earn you some interest in savings account. Imagine if it is D10,000, you could even start business with that.
Let me explain it a bit with numbers.
If you have D100 today and save into an account that pays on a monthly basis at 5% interest per annum ( monthly compounding), then the savings account balance will be D105.04 by the end of year one or D110.34 by end of year two.
Time value of money and retirement savings
We can explain the concept of time value with a more practical example. Let us meet two gentlemen who just retired at age of 65. We will call them Grandpa A and Grandpa B.
Grandpa A started saving D5,000 per annum in a special retirement savings account which pays 7.5% per annum compounded monthly. He started at the age of 25 and stop at the age of 34; meaning 10 years of saving.
Grandpa B also started saving D5,000 per annum in a special retirement savings account which pays 7.5% per annum also compounded monthly. However, he started at age 35, when Grandpa A have stopped. Grandpa B continued the saving till he retired at age 65, meaning 31 years of saving.
At this point can you guess who would have retired with more balance in his retirement savings account?
- Grandpa A who saved D50,000 within 10 years ( earlier)
- Grandpa B who saved D155,000 within 31 years (later)
Most people would expect Grandpa B to have higher savings balance. That could not be correct unless we fail to consider the time value of money.
Grandpa A actually retired with more balance in his savings account compared to Grandpa B. Grandpa A started savings 10 years before Grandpa B and the time value of the early annual savings (annuity) earned him much more balance before B started.
See the summary in the table below:
|Name||Grandpa A||Grandpa B|
|No of years saving||10||31|
|Savings value at age 65||D 783,644.28||D635,269.18|
Download the detail Excel File for this calculation here.
You will have realized that Grandpa A, who contributed much less than Grandpa B has a higher savings at retirement age. This is because he started 10 years early before Grandpa B. As you can see from this example, the power of compound interest is more extra-ordinary when money is steadily saved and left to grow over a long period.
Time value of money can only be beneficial to those who start to save and invest early.
How do you apply the concept of time value of money in your daily life? And if this is your first time reading about the topic, please tell me how this article has help your understanding. Use the comment box below.