Time Value of Money

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Time Value of Money

• Family Economics Financial Education

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Time Value of Money

• Time value of money -- Money to be paid out or
  received in the future is not equivalent to money
  paid out or received today

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Compounding Interest

• Compounding interest -- Earning interest on
  interest
• Make your money work for you
• Developed because compounding interest causes
  money to make money

1,000 Invested Compounded Annually at 10 Interest Rate 1,000 Invested Compounded Annually at 10 Interest Rate
1 Year 2 Years
1,104.71 1,220.39
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Simple Interest

• Simple interest -- Interest earned on the
  principal investment
• Principal -- The original amount of money
  invested or saved
• Amount invested x annual interest rate x number
  of years interest earned
• Ex. 1,000 x 0.10 x 2200

1,000 Invested at 10 Simple Interest Rate 1,000 Invested at 10 Simple Interest Rate
1 Year 2 Years
1,100.00 1,200.00
1,000 Invested at 10 Simple Interest Rate 1,000 Invested at 10 Simple Interest Rate
1 Year 2 Years
1,100.00 1,200.00
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Three Factors Affecting the Time Value
Calculations

• Time
• Amount invested
• Interest rate

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Time

• The earlier an individual invests, the more time
  their investment has to compound interest and
  increase in value

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A Little Goes a Long Way

• Sally Saver puts away 3,000 per year in her IRA
  account earning 10 - she does this for 10 years
  then stops.
• Sally accumulates 1,239,564 by the age of 65.

• Ed Uninformed waits until he is 28. He must
  contribute 3,000 to his IRA account earning 10
  for 38 years.
• Ed accumulates 1,102,331 by the age of 65

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Amount Invested

• Investing only a small amount a month is better
  than not investing at all
• Ex. At 8 interest, invested at age 17, one
  dollar per day will become 17,865.52 by age 65
• The larger the amount invested the greater return
  a person will earn
• Always pay yourself first
• Savings should be a fixed expense

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Amount Invested continued

• 70-20-10 Rule
• 70 Spent
• 20 Saved
• 10 Invested
• Flexible expenses can be decreased in order to
  increase the amount a person is able to invest

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The Costs Add Up
Investing at age 18 at 8 interest until age 65.
Item Average Yearly Expense Future Value
Daily cup of coffee at 2.50 912.50 38,704.46
Eating lunch out 5 days per week at a cost of 5-10 each time 1,300.00-2,600.00 55,140.60 1,10281.21
Daily can of soda or chips at 1.00 each or both a can of pop and chips 2.00 365.00 730.00 15,481.78 30,963.57
Daily candy bar at 1.00 365.00 15,481.78
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Interest Rate

• The percentage rate paid on the money invested or
  saved
• Higher interestmore money earned

1,000 Invested Compounded Monthly 1,000 Invested Compounded Monthly 1,000 Invested Compounded Monthly 1,000 Invested Compounded Monthly
Interest Rate 1 Year 5 Years 10 Years
4 1,040.74 1,221.00 1,490.83
6 1,061.68 1,348.85 1,819.40
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Risk

• A higher interest rate generally has a greater
  risk
• Risk -- The uncertainty of the outcome of an
  investment

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Fixed Interest Rate

• Fixed interest rate -- The rate will not change
  for the lifetime of the investment
• Having a savings or investment plan with a fixed
  interest rate guarantees a specific return but
  can provide a moderate risk
• If the average interest rates rise, the amount a
  person earns from this type of investment will
  not increase

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Inflation

• Another consideration with interest rates is
  ensuring the interest rate is higher than the
  rate of inflation
• Inflation -- The steady rise in the general level
  of prices
• Ex. If an individual has money invested at 4
  interest and the inflation rate is 4, the
  individuals wealth will stay the same

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Time Value of Money Calculations

• Present value
• PV(FV)(1i)-N
• Future value
• FV(PV)(1i)N
• Financial calculators may be used to complete
  these calculations.

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Calculation Components

• Present value (PV) -- How much money a person has
  today
• Future value (FV) How much money a person
  expects to have in the future
• Interest rate (i) The percentage rate paid on
  the money invested or saved
• Time (N) -- Length of investment
• Calculated by the number of compounding periods
  (daily, monthly, or annually)

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Review

• Compounding interest earns interest on interest
• Increased timemore interest earned
• Higher principlemore interest earned
• Higher interest ratemore interest earned