Time value of money and compounding

Understanding how the time value of money can help you make better financial decisions is important for managing your money more effectively. Time and compounding returns help your money grow exponentially over the long term, steadily building wealth.

How does the time value of money impact our finances?

The time value of money means a unit of money is worth more today than the same amount in the future. Simply put, £1 today will buy more than £1 one year later. There are two elements to the time value of money, inflation and opportunity cost.

Inflation

Inflation causes price increases eroding the purchasing power of money over time. If annual inflation is 5%, an item costing £1 now will cost £1.05 a year later.

Opportunity cost

Financial opportunity cost refers to the lost income from not investing or saving money. It is like hiding £100 under your mattress for a year. After a year you still have a somewhat dusty £100 but the purchasing power will have decreased by the prevailing inflation rate. You have also given up potential income that you could have made from saving or investing the money.

Saving £100 for a year in an account paying 5% interest will yield interest income of £5. Putting the money under your mattress accumulating dust means you forgo earning interest which is an opportunity cost of £5.

Time value of money and financial decisions

There are several financial formulas to calculate the impact of time on the value of money. They are useful to compare investment and saving opportunities as well as helping you calculate how much you should save for retirement.

Some examples of the time value of money (TVM)

You are considering saving £200 a month in an account paying 4% compounding interest. You want to know how much money you will have after 5 years. Using the formula for the future value of an annuity (regular contribution), your will have £13,658 after 5 years.

Assuming annual inflation of 2%, what is this amount worth in today’s money? It’s roughly the equivalent purchasing power of £12,370 today.

It’s time to get on the property ladder and you are saving for a deposit. You are hoping to save £20,000 in 3 years. With a savings account paying 6% interest, how much must you save every month to achieve this? You will need to save £506 a month.

You want to retire in forty years with the equivalent of £750,000 in today’s money. Assuming an annual return of 5% on your money and annual inflation of 3% you will need to save £ 1,085 a month. In this example, the net return after inflation is only 2% whereas investing in the stock market should hopefully provide you with a better return on your money.

Visit our shop

Take a look at our Time Value of Money e-product. The 4 page booklet provides further guidance on how the time value of money can help you make better financial decisions. It also includes a handy Excel TVM calculator to help you with the maths.

If you want to learn more about the time value of money the following article on Investopedia, explains the concept and formulas in greater detail:

Time Value of Money Explained With Formula and Examples (investopedia.com)