Topic: Time value of money - what does it means in Financial planning?

How does it impact our savings?

Consider this when you're planning for your retirement: If inflation is 3% per year, what costs Rs. 1 today will cost Rs. 2 in 24 years. The value of money depreciate over the period of time because of inflation. To properly calculate the future value of your investments, you need to account for the impact of inflation. You're only earning if the growth of your investments is higher than the rate of inflation.

Time value of money is the backbone for financial planning. In simple understanding time value of money is the value of money figuring in a given amount of interest for a given amount of time. For example Rs. 100 of today's money held for a year at 8 percent interest is worth Rs. 108, therefore Rs. 100 paid now or Rs. 108 paid exactly one year from now is the same amount of payment of money with that given interest at that given amount of time

The method also allows the valuation of a likely stream of income in the future, in such a way that the annual incomes are discounted and then added together, thus providing a lump- sum "present value" of the entire income stream.

In the savings and investment it works in favour of you and in the borrowings or loans it works against you.

Time value of money impacts our savings in quite a big way because if you are earning interest which is lower than the rate of inflation (which is the case in most of the countries in this economic downturn), then your money is really just depreciating over time. Like nitinsood says, use the Rule of 72 to calculate in how many years inflation will double.

A $100 today will be worth $______ if inflation is 3%. Thus, 72 / 3 = 24 years, thus $100 will be worth $0 in 24 years. Here's an academic view of time value of money:

Consider you invest $100 in a savings account that pays 10% interest per year, how much will you have at the end of the 1st year? This is quite simple, you will have $100 x 10% = $110. This $110 is equal to your original principal plus $10 in interest that you earned from your bank. Therefore, $110 is the future value (FV) of $100 invested for one year at 10% interest, and this simply means $100 today is worth $110 in 1 year, given a 10% interest rate. We must therefore derive a mathematical formula to perform this calculation of present/future values. Source: Time value of Money

Thus in general, if you invest for one period at an interest rate of r, your investment grows (1 + r) per dollar invested. In the example above, r is 10% so your investment would grow (1 + 0.10) = 1.10 x $100 = $110

Investing for More than One Period

Referring to our original example of $100 invested at 10% annual interest rate, what will we have in 2 years, assuming the interest rate does not change? If the entire $110 is left in the bank in the 2nd year, we will earn ($1 + 0.1) = 1.10 x $110 = $121. This $121 is the future value of $100 in two years at 10% annual interest. This $121 has three parts to it:

a) The first part is the $100 original invested

b) The second part is the $10 in interest earned in the first year ((1+0.1) x $100) - $100 = $10

c) The third part is the $11 earned in interest in the third year ((1+.01) x $110) - $110 = $11

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