Last Updated on May 12, 2026
Time value of money and compounding
Understanding the time value of money can help you make better financial decisions, which is important in 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 in a year’s time. There are two elements to the time value of money: inflation and opportunity cost.
Inflation
Inflation results in price increases, which erode the purchasing power of money over time. If annual inflation is 5%, an item costing £1 now will cost £1.05 in a year’s time.
Opportunity cost
Financial opportunity cost refers to the lost income or gain from not investing or saving money. It is like hiding £100 under your mattress for a year. After a year, you’ll still have a somewhat dusty £100, but the purchasing power will have decreased by the current inflation rate. By not saving or investing the money, you have also missed out on potential interest income and investment returns.
If you put £100 in a savings account with 4.5% interest, after a year you will earn £4.50 in interest. If you stuff it under your mattress, you’ll gain some dust bunnies but lose out on this income. This is the opportunity cost of not putting the money in a savings account.
Time value of money and financial decisions
There are several financial formulas for calculating the impact of time on the value of money. They are useful for comparing investment and saving opportunities and can be helpful as a guide for calculating 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% compound 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), you will have around £13,650 after 5 years.
Assuming annual inflation of 2%, what is this amount worth in today’s money? It has 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 inflation of 3%, you will need to save around £ 1,085 a month. In this example, the net return after inflation is only 2%, whereas investing in the stock market should hopefully provide a better return on your money.
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Take a look at our Time Value of Money Excel spreadsheet and booklet. 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)