Money doesn’t grow on trees, but it does grow in banks. The growing of money over time is known as the time value of money.
Would you rather have $500 now or $638.14 in five years? Most people would want the money now. But if you wait five years you can have more money thanks to the time value of money.
If you saved your $500 for five years at 5% interest each year, you would have $638.14 at the end. You could have an extra $138.14 instead of just $500.
When people say time is money, they are not lying!
So how do I know I’ll have $638.14 in 5 years? A simple math equation that looks like this:
$500 + (500 x. 5% or .05) = $525
$500 is my starting amount. I then multiply that $500 by 5% (which is also .05 if your calculator doesn’t have the % button). (500 x .05) = 25. The $25 is my interest for the first year. I add that interest to my original amount (called principal) of $500 and I get $525 after one year of saving at 5%.
But I want to know how much money I will have after five years. So I do the equation again for year two, but now my principal is $525 because of the money I made my first year of saving. My year two equation looks like this:
$525 + (525 x .05) = $551.25
You just repeat this formula for however many years you plan on keeping the investment, in this case five years. That’s how I found out I would have $638.14 after five years.
There is an even easier way to calculate this if you use the fancy calculators needed to do Algebra using exponents. If you do the equation with exponents you only have to do the equation once (instead of once for every year).
Then the math equation looks like this:
$500 X (1 + .05)5
The exponent (5) is the number of years the investment will gather interest. If the investment is for three years, do 3. The (1 + .05) is the interest rate with the adjustment that leaves out the 500. It sounds complicated, but doing the math equation is much easier than explaining it. This equation simply means you do not have to repeat the process five times.
So what is the point of all this math? The point is to help you plan where to invest your money and for how long.
Put it this way: What if you won the lottery and you could choose $500 today or $700 in five years? If the current interest rate was still 5% and you wanted the most money possible you would have to figure out what was the best option. Using the time value of money calculations we did above we can see that $700 in five years is more than $500 invested at 5% for the same time period (which is $638.14). Therefore, we would choose to wait five years so we could get the most money possible.
That is why it is useful to know the time value of money.