Time value of money

A $100 is a $100 is a $100. No brainier? Theoretically yes. But practically – life is more complicated. One of the reasons is the concept of time value of money!

Time value of money – is an interesting relationship between money and time! It is visible everywhere.  Money is usually worth more today than same amount will be worth some time in future. (here is how Investopedia defines it!).

This time value of money manifests itself in 2 ways primarily – inflation and compounding.

time value of money

Inflation

We keep on reading about inflation in news and see it all around in day to day lives. However, we usually tend to realize the inflation that is happening/ has happened only on a slightly longer time horizon – When 3 years later the “price” of something.

In future, the price of things that cost X may be 2X or 3X or even 10X – depending upon variety of factors, inflation being one! How often do we fail to consider this? 

Compounding:

The money in your bank account is not the same few years down the line if it is an interest bearing account. So if your money earns like 7-75.% per annum (current interest rates in India), it doubles every 10 years or so. 

At the same time, suppose you take money from bank or anyone, promising to return it after 10 years paying this interest rate (7-7.5%) you will have to return double the amount of money! 

This is the wonder of compounding! Compounding can work for you …or against you!

Inflation plus compounding

If you are a saver, your money grows every year if you earn a interest rate which is a positive number! At the same time, inflation can potentially take away the returns. That way your real returns may be able to beat inflation – or may actually lag behind – though the concept of compounding may say otherwise.

While making our financial plans for future – we often tend to underestimate either or both of these factors – inflation as well as compounding! 

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So, if someone take s $100 from you and returns it after $100 after 5 years – you are probably not receiving same money. If the phone or laptop you bought for $1000 few years back is available at $500 three years later, the price you pay is not just half but more – because the value of $1000 would have changed.

Someone reminiscence the old days with cheaper prices of things with today is probably making a comparison on its price then and now – without factoring in the value of money would have changed over a period of time! 

Different times have different value of money. Most of us know that. Most of the business and economics classes teach it. But, often we fail to realize that – and fail to factor it in while making our plans!

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