What is the time value of money concept?
Time value of money simply means that it is better to have a dollar today, than a dollar at a date in the future.
Consider these questions:
Q. Would you rather receive $907 today, or $1000 in 2 years time?
A. Assuming you could earn 5% annual interest on your $907, you’d have $1000 in 2 years time. Both options are worth the same amount to you.
Q. Would you rather receive $613 today, or $1000 in 10 years time?
A. The answer is the same as the first question. Both options are worth the same to you assuming a 5% annual interest rate.
These figures are not staggering because of the current low interest rates. If you were able to earn a lot more interest than 5% on your money then the difference between the values would be a lot larger.
The above examples show the effect of growing your money over time. My last post illustrated the effect that compound interest has on your savings.
Perhaps an even more important example would be the following:
- You have worked out that you need $1,000,000 (one million dollars) in savings to generate an annual income of $50,000 (assuming a 5% annual interest rate) for your retirement.
- You intend to retire in 11 years time.
How much will a million of today’s dollars be worth in 11 years?
How much do you really need to have saved in 11 years to generate the equivalent annual income?
Inflation reduces the spending value of your money. Depending on your age, you can probably remember various everyday items (such as milk) that you used to be able to purchase for a fraction of today’s price. To ensure that your retirement income covers this increasing cost of everyday goods, you need to allow for inflation in your calculations.
For this example, let’s say that inflation is at 3% per annum.
In 11 years time if you have saved $1,000,000 that will be equivalent to $722,421 of today’s dollars.
To have the equivalent of today’s $1,000,000 in 11 years time, you need to have squirrelled away $1,384,234.
This is why it is so important to not just save money, but also to make sure that you are getting a return on your money that is higher than the current inflation rate.
Assuming inflation of 3% p.a., and interest earned of 5% p.a., $1,384,234 will generate income of $69,212, which in 11 years time should give you the same spending power as $50,000 would today.
To have the equivalent of today’s $1,000,000 in 11 years time, you would need to have saved $1,384,234.
To have the spending power of today’s $50,000 in 11 years, you would need your savings to be generating income of $69,212.
My next post will show you how these examples were calculated so that you can use the formulae for your own situation.