The Time Value of Money: All you need to know!
You need to understand your relationship with money. To do that, you need to understand more about money. You can do so by understanding the time value of money (TVM).
TVM and financial planning
TVM is an essential component of financial planning, and it covers all the areas of financial planning. When you plan for your long-term goal, TVM comes in very handy. For example, when planning for your child's education or retirement, you have to bring in your knowledge of TVM. It serves as a tool for you to compare prospective investment options and help you make sound financial decisions. If you plan to do financial planning on your own, ensure you get this concept right.
What is the Time Value of Money?
TVM refers to the notion that the money you receive today is not worth the same as an equal amount of money received at a future date.
Let us set aside all the technicalities and understand it in simple language. Assume a scenario - you were expecting some money from your uncle today, but he tells you that he will give you the money next year. How do you feel? You don't feel good because you know you could have done a lot with the money today than you could do after one year.
It advocates that you are better off to have cash now than later. Why? The money you have today, you can invest it, and the returns it will make will be higher than what you would make if you invest the same money after two months. The underlying concept of TVM is that money has tremendous growth potential. If you delay investing your money, you lose a chance to earn from it.
In financial planning, you are not supposed to do it. You create your goals and start investing now in the right financial instrument. TVM helps you in the process.
Understanding it in more detail
In the above example of getting money from an uncle, you decide to go and talk to your uncle. You tell him that you understand TVM and hence, you want the money now. To check your knowledge, he gives you two options. You can take Rs 1,00,000 today or take Rs 1,04,000 next year. Which option are you going to choose?
If you understand TVM completely, you will choose the first option. You know that you can invest Rs 1 lakh today in fixed deposits and make more than Rs 1.04 lakh after a year. If you are high-risk taking, you can invest in equity and perhaps earn much more than what he is offering you after one year.
So whenever you are dealing with money - bring in the above knowledge to calculate and make your decisions around money.
TVM formula can vary based on your financial circumstances. However, the below formula works in most cases:
FV = PV x [ 1 + (I/ N) ] (N*T)
here, FV is the future value of money,
PV is the present value of money,
I is the interest rate,
N is the number of compounding periods annually
T is the number of years in the tenure
For instance, if you invest Rs 1 lakh for five years at 10% interest, the future value of this one lakh will be Rs 161,051 as per the formula.
TVM and inflation
Inflation is another topic you need to understand before doing financial planning. Let us understand it with a simple example. Assume your father invested Rs 1 lakh in land in 1980. Now the cost of the property is Rs 50,00,000 - 50 times returns.
However, if you consider average inflation of Rs 8%, Rs 1 lakh invested then is the same as Rs 20 lakh today. So if your property value is only Rs 20,00,000 today, you have not made any returns in all these years. Even if Rs 50 lacs, your net return is only Rs 30,00,000.
We hope the above information will help you know the worth of your money today. Also, when you create goals and achieve them, you will factor in inflation to calculate your net profits. In the next article, we move to another important concept - diversification.