Understanding the Time Value of Money – The Basics

The understanding that the more time you allow for your money to grow in your investment, the higher your return, is one of the most basic fundamental laws in finance. In simple terms, this law states that a dollar today is worth more than it is in the future.

By investing your money into a financial vehicle like stocks, bonds, real estate, you are foregoing your immediate use of your money in hope that you will cash out (long term and short term) in the future and get something extra for it.

For example if you were to invest $1000 into a savings account today at the rate of 5% yearly, then your account will be worth $1050 in a year if you do not touch it. You gained this interest because essentially you allowed the bank to borrow your money for other uses, and you are paid back within a certain amount of time.

Now let’s look at the time value of money in a negative way. If you were to spend that $1000 today on merchandise instead of investing it in a financial vehicle, then you will have lost money because you will need to pay off all that debt on your credit card with money from the future, which is going to be worth less than what it is now. Are you now beginning to understand the good and the bad of the time value of money?

Always consider the time value of money when making any type of big purchases. It might be a smarter decision to invest than spend, and vice versa.

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