What would you like to save for? A nice retirement? Dream vacation? Capital to start a business?
Do you find it difficult to save money? If so, maybe it’s because you don’t realize the power of saving consistently over time.
But once you are able to grasp the power of this, you just might be more willing to make saving a regular habit.
What is the Time Value of Money?
As one of the most useful concepts in finance, it says that if I give you $1 today, it’ll be worth more than $1 that you get a year from now. Why? Because $1 can be invested today and earn interest.
Let’s say you invest $1 in an account that earns 6% interest. At the end of the year, the dollar would have grown to $1.06. You’ve earned interest for delaying gratification and not spending for a year.
If you’re a bit of a math geek like I am, here’s the calculation behind the numbers:
FV = PV (1 + i)^n
FV = future value, PV = present value, i = interest rate, and n = number of periods.
In our example above, PV = $1, i = 6%, and n =1, leading to the FV of $1.06.
How the Time Value of Money Can Help
This formula can be used to answer questions such as:
- If I have a certain amount of money today, what will it be worth in the future if invested at a specific interest rate?
- If I invested a certain amount of money on a regular basis and constant interest rate, how much would I have in the future?
How it Works
The power of the time value of money comes from compound interest – which is interest earned on interest. This way, your money grows exponentially rather than in a linear pattern. In fact, compound interest is so powerful that it’s been called the “eighth wonder of the world.”
Back to our previous example, let’s say the entire $1.06 was invested for a second year and earned 6%. Guess what the future value at the end of the second year would be?
FV = PV (1 + i)
FV = 1.06 (1 + .06)
FV = 1.1236
The earnings in the second year, $0.0636, is made up of interest on the original dollar ($0.06) and interest on the 6 cents earned after the first year (.0036). Your interest has also earned interest.
If you were to repeat this process for a third year, your money would grow to $1.19. But guess what would happen if you kept it up for 12 years? You’d double your money. How would you like to double your money every 12 years?
Making Consistent Deposits
What if, instead of a single deposit, you made regular deposits on an annual basis? Let’s say you saved $200 at the beginning of every year for 5 years. At an interest rate of 6%, how much would you have at the end of those 5 years? $1,195.06. This is only after investing $1,000 of your own money.
But seeing these dollar amounts may not be enough to inspire you, so let’s try another example.
Want to Earn $1 Million?
If you started investing early, say at age 20, you could earn $1 million by the time you reach age 65. Here’s the math.
Invest $4,434.43 at the beginning of every year in an account earning 6%, at the end of the 45 years, you’d be a millionaire! The nice part about this is that you’d only be investing less than $200,000 of your own money.
This stresses the importance of starting early, saving consistently, and staying disciplined.
Where can you find Investments Earning 6%?
These days, it may be difficult to find such an investment. One possible source is Lending Club, which is advertising average returns of over 9%. If you’d like to check them out, you can learn more and receive $25 free to try them out.
What would you like to save for?
Photo by kevinzhengli