Chapter 3 - The Time Value of Money (TVM)

This chapter is on a topic called the time value of money. The time value of money is the cornerstone of the entire financial planning process. In this chapter, we'll discuss the concept of the time value of money. There is also a math skill called the time value of money. If you are looking for help on performing financial calculations, refer to the math skills portion of the book.

What do we mean when we say "the time value of money"?

Consider the following scenario. Imagine you won $1,000 on a game show. The host comes to you with an offer. You can get your $1,000 today, or you can your $1,000 one year from now. Would you rather have the money today, or in one year?

You'd rather have it today, wouldn't you? Almost everyone would. Focus on that feeling in your head that tells you that you'd rather have $1,000 now instead of $1,000 in a year. That feeling is called "the time value of money". It's our natural human instinct to prefer to have money today over having it later. We prefer now over later, always.

The time value of money says that money has different values across time. The closer money is to the present, the more you value it. But why does money have different values over time? Why do we place a higher value over dollars today versus dollars tomorrow?

The answer relates to the concept of “opportunity costs.” Opportunity costs are the value of the next best alternative that you must give up whenever you make a choice. For example, if you choose to major in Engineering, you have to give up majoring in Business.

$1,000 today is worth more to you than $1,000 next year because there are ways you could use that money now. You could invest the money and earn interest. Or you could use it to fix your flat tire or repair your water heater. There are limitless possibilities for how you could use the money today. If you wait a year to collect your money, you lose out on the chance to use the money now. In this way, the time value of money is linked to its opportunity cost.

Another factor that affects the time value of money is inflation. We’ll save the details of why inflation happens for an economics class. For our purposes, it’s important to know that the prices of things tend to rise over time. If you don’t believe it, just talk to a retired person how much a gallon of milk or a movie ticket cost when they were young. Because of inflation, a dollar today can literally buy more things than a dollar in the future.

Let’s look at a different scenario now. Suppose the game show offers to give you $1,100 next year or $1,000 today. What would you do this time?

In order to answer this question for yourself, you have to ask yourself if having $1,100 next year is worth more to you than having $1,000 today. If you wait, you will have more money - but you have to wait! Is the wait worth $100 to you? Some people will say that that is worth the wait. Others will say that it is not the wait. Present oriented people dislike waiting more than future oriented people. This means that they are going to demand more reward for waiting.

The time value of money formulas are an attempt to put some math around this feeling. If you can estimate how much reward you want for waiting to spend your money, you can use the time value of money calculations to calculate how the value of money will change over time.

Here are a few questions you can answer using the time value of money formulas. What will my investment be worth in ten years? If I want to have $10,000 in ten years, how much do I need to invest today? How much do I need to save each month to reach my goal? As you can see, these questions all involve changes in money over time. This is why this principle is called the time value of money.

This is an excellent time to watch Lecture 3 from the course pack!