Why is time value of money important
The concept of the time value of money has been around for decades. Below, we’ll examine why the time value of money is so important and how people can actually use it to their advantage in real estate.
What Is the Time Value of Money?
The time value of money or TVM is an important conceptualization of why money today is worth more than money in the future. In some respect, it means that a general basket of goods and services bought now will cost a lot more a few years from now. This is because buying power decays over the long term.
On the other hand, individuals can invest to maintain buying power over time. This is common for analyzing opportunity costs as well as for retirement planning. Using formulas for present value, future value, and compound interest opportunities will help with optimal decision-making.
Formulas for Calculating the Time Value of Money
The time value of money formula is broken into two parts — the present value and future value of money. For each calculation, the following variables will be used:
- PV = Present Value
- FV = Future Value
- s = Sum of Money
- i = Interest Rate
- c = Number of Compounding Periods per Year
- n = Number of Years
The present value determines how much the money on hand will be worth in the future. The breakdown is illustrated with this formula:
PV = s / (1 + i)(c x n)
The future value then is reversing the above — it shows how much money in the future is being valued today. It can be broken down with this formula:
FV = s x (1 + i)(c x n)
Finally, in the case of recurring inflows, money could potentially be compounded monthly, quarterly, or annually too. For this formula, we use:
FV =PV x (1 +( i / c))(c x n)
Why Does Money Have Time Value?
There are a number of reasons why money is worth less now than at some period in the future. Two core factors influencing this include:
- Interest Rates
Inflation refers to the increase in the price of goods and services typically influenced by demand and supply metrics. In periods of high inflation, general expenses rise rapidly. As such, the purchasing power for both consumers and businesses will decrease over time. For example, let’s say $1,000 currently covers a person’s travel expenses or rent. The difference between the time value of money and inflation is that if inflation is sustained at 5% for the next decade, the same expense would be more than $1,600 ten years later. Hence, that original $1,000 is significantly less than the amount of money that would actually be required to cover future costs.
Interest rates are the rate of return that is payable by borrowers or earned by lenders on loans. For borrowers, interest is referred to as the annual percentage rate or APR, and for lenders, it is referred to as the annual percentage yield or APY.
When interest rates climb, so too does the capacity for businesses and consumers to make more money. As such, money invested or used for lending now can potentially be worth more over time. Let’s examine this through compounding periods.
Time Value of Money Opportunity Costs
The ability to earn interest is one of the most important considerations for the time value of money as it indicates future cash flow opportunities from investment returns. Yet, the compounding interest from investments isn’t always worth it.
Here’s an example to illustrate. Let’s say the current APY available is 5%. So, given the choice, would it be better to claim a lump sum of $100,000 now or $125,000 in five years’ time?
Using the formula above, $100,000 invested at a 5% APY and compounded annually works out as:
$100,000 x (1.00 + 0.05)5 = $127,629
In this case, it would be more worthwhile to claim the $100,000 now as it has the power to be worth more in the future. But, what if the interest rate is just 2.5%? In that instance, it would be:
$100,000 x (1.00 + 0.25)5 = $113,141
When the discount rate of interest is applied, it would be more favorable to opt for future payment.
Another element to consider is measuring the above against receiving monthly payments, as is the case with many seller financing deals. The payback period ignores the time value of money. However, even if the overall payment is lower than that of an outright sale of a mortgage note to a note buyer, the monthly payments can be compounded more often which could reap higher rewards.
Looking at current macroeconomic conditions, the time value of money is being watched closer than it has been in years. It’s a key determinant of what provides buyers and sellers of real estate — and everyone in the capital markets for that matter — with the information needed for better decision-making.
Cited article sources
- Investopedia. (Updated September 13, 2022). “Inflation: What it is, how it can be controlled, and extreme example.” https://www.investopedia.com/terms/i/inflation.asp