Why a dollar today is worth more than a dollar in a year?

(Time value of Money – TVM-1)

PC – Shuttershock

“A bird in hand is better than two in bush”, someone would say this. It seems to be a very simple question with an easy answer. It’s an adage which tells us that its risky to depend on something that’s not in your hands already.

What if I told you, that even if you have a written legal guarantee, that you would get the money next year still you should always go for the option of getting it today. If you get the money today you can invest it and earn interest on it.

Interest – what we earn by keeping our money in bank, in Fixed Deposits or investing it elsewhere.

There are two types of interest

1. Simple Interest (that we pay on automobile/ personal loans),

2. Compound interest (that we earn on our investments)

Let’s understand the difference between simple interest and compound interest with an example.

E.g. Mr. X is offered 3 options for $100 he is supposed to receive as compensation for his work –

Option 1 :  He can receive the sum in 5 years

Option 2 :  He can receive the sum today and invest @10% simple interest

Option 3 :  He can receive the sum today an invest @10% compound interest

Key findings:

1. Option 1 returns will be always be lowest – non interest earned for 5 years

2. Option 3 (compound interest) returns will always be higher than Option 2 (simple interest)

Graphic view of result of different options – extrapolated to 20-year horizon

Power of compounding

1. Difference between returns from compound interest and simple interest keeps increasing

But why is that so – because of compounding i.e. interest also becomes principal next year and even the interest earns interest. Therefore, every progressive year interest earned is added to principal amount and starts earning interest in coming years.

So how does compounding look like in real life –

Simple Interest Vs Compound Interest

Compounding has big impact on returns earned by your investments. Especially when investments are for medium to long-term horizon, the impact of compounding increases the returns by several folds. Understanding the principle of compounding is one of the most important and fundamental part to understand time value of money (TVM).

In current example itself you can see how (over 20 years) compounding helps end-corpus to be more than double than that with simple interest.

The three key takeaways from this article –

1. Money with you today is more valuable than same amount tomorrow due to its return earning capacity

2. Compound interest is always preferred to simple interest due to higher returns

3. With increasing time span returns from compounding grow at much sharper rate than simple interest

These are the same elements that form the basis of concept of time value of money (TVM). With this we can finally conclude that money available today is more valuable than getting the same amount tomorrow.

In next article we will discuss the application of TVM i.e. how you can use these TVM principles in your day to day life. Specially how TVM can help you ‘retain and increase the value of your money’.

#compounding #personalfinance #timevalueofmoney #Investing #financialplanning #TVM