Understanding the Importance of Time Value of Money and How It Impacts You
One of the most powerful concepts of
learning about investing is to understand and utilize the power of compound
investing. By applying compound
investing, an investor is able to earn more without working longer or harder. If this concept is not applied, the
individual saving for retirement who lives paycheck to paycheck will miss out
on “having their money work for them”.
The concept is simple, but not easy to calculate: money which is
consistently reinvested will bring exponential rewards to the investor.
This article attempts to shed light on the importance of understanding compound
investing and bring forth distinctions to help the finance student gain an edge
whenever encountering definitional or quantitative finance problems in this topic.
It is critical to mention that there
are two types of interest: simple interest and compound interest. Simple
interest is solved by finding the product of the principal, rate,
and time. This method of investing is most popular when the
investor is seeking to earn a return after saving money in a bank. The
formula for simple interest is as follows:
I = p • r • t
In contrast, if the investor
reinvests their earnings, the investor is earning interest on interest.
In comparison to simple interest, compound interest helps the investor earn
exponential growth, as their savings will begin to increase at an increasing
rate. For example, let’s say that Cindy wants to invest her money for the
next 20 years and can lock-in her investments with a rate of 11% per
annum. She has $10,000 she can invest today and her first earned interest
will be at the end of Year 1 from today. How much will she accumulate at
the end of Year 20?
We will apply this formula as
follows:
FV = PV((1 + r)t
FV = 10,000 • *((1.11)20)
FV = $80,623.12
If Cindy is able to consistently
reinvest her money interest on interest, she will receive $80,623 at the end of
20 years!
Let’s compare this with simple with
simple interest. If Cindy invested her money in a savings account without
reinvesting any of it, this is what she would earn at the end of 20 years:
I = p • r • t
I = ((10,000) • (0.11) • (20)) +
10,000
I = $32,000
Cindy would only earn $32,000 after
waiting 20 years. This also does not include the gradual increase of
inflation or hidden fees from banks. Thus, Cindy’s time and effort to
learn how to apply compound interest can truly make a difference in what she
will be able to earn! The differences are staggering!
Let’s look at a chart to see how
compound interest compares to simple interest:
|
Years
|
5%
|
10%
|
15%
|
20%
|
|
1
|
1.05
|
1.10
|
1.15
|
1.20
|
|
2
|
1.10
|
1.21
|
1.32
|
1.44
|
|
3
|
1.16
|
1.33
|
1.52
|
1.73
|
|
4
|
1.22
|
1.46
|
1.75
|
2.07
|
|
5
|
1.28
|
1.61
|
2.01
|
2.49
|
|
6
|
1.34
|
1.77
|
2.31
|
2.99
|
|
7
|
1.41
|
1.95
|
2.66
|
3.58
|
|
8
|
1.48
|
2.14
|
3.06
|
4.30
|
|
9
|
1.55
|
2.36
|
3.52
|
5.16
|
|
10
|
1.63
|
2.59
|
4.05
|
6.19
|
|
11
|
1.71
|
2.85
|
4.65
|
7.43
|
|
2
|
1.80
|
3.14
|
5.35
|
8.92
|
|
13
|
1.89
|
3.45
|
6.15
|
10.70
|
|
14
|
1.98
|
3.80
|
7.08
|
12.84
|
|
15
|
2.08
|
4.18
|
8.14
|
15.41
|
|
16
|
2.18
|
4.59
|
9.36
|
18.49
|
|
17
|
2.29
|
5.05
|
10.76
|
22.19
|
|
18
|
2.41
|
5.56
|
12.38
|
26.62
|
|
19
|
2.53
|
6.12
|
14.23
|
31.95
|
|
20
|
2.65
|
6.73
|
16.37
|
38.34
|
The line chart above illustrates the
high level of potential rewards to the investor who is both consistent and
committed to investing. The most
important factor of time value of money is time. The reason for this is that time is always
being spent. Thus, it is critical to
begin compound investing now. If an investor were to delay creating their
individual portfolio, the large gains in the last decade prior to taking money
out of the investment would excise off tremendous rewards!
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