Time Value of Money

The idea behind the time value of money is simple: it is better to have $100 today than $100 in the future. Although this idea may seem obvious, it is important because it drives all financial decision-making.

Having $100 now is more valuable than having $100 a year from now because you have control over the $100 now. You can do something with the $100 now; for example, you can invest it and make it grow, or put it into a savings account and earn interest, thus making it worth more than what you would have had by taking the $100 in the future. Moreover, inflation also makes $100 worth less a year from now.

Example

Understanding the time value of money becomes important as you start comparing ways in which you spend and receive money. For example, suppose a department store offers you two different ways to purchase a television. You can either spend $1,000 today, or $1,100 in twelve months. Which do you choose?

You can figure out that the extra $100 over the course of twelve months is equivalent to 10% interest compounded annually. If you’ve got the $1,000 now, then it’s better to pay it now — and if you don’t, you should not be buying the TV in the first place!

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