What is the Time Value of Money? (And How it Affects Your Saving Habits)

Taking steps towards financial wellness starts and ends with educating yourself. With just a quick Google search, anyone can learn everything there is to know about investing, blockchain, and other complex topics.

Learning about these subjects is a great idea, but you must never skip the fundamentals. Entering a venture without a firm grasp of basic financial concepts is no different from traveling without a map. To help you reach your goals with ease, here's a foundational concept in finance you should know about: the time value of money. 

What is the Time Value of Money?

The time value of money (TVM) states that the savings you have now can increase in the future due to its potential earning capacity. Thanks to compounding interest, any amount of cash invested sooner has more value since it has a longer time horizon or the time one needs to wait before expecting their money back.

For example, let's say we have a deposit account with a 5% annual interest rate. If we deposit only P20,000 today and leave it for ten years, the account will have a higher value than if we made a larger deposit of P25,000 but only kept it for five years.

Economic factors and trends may also play a huge part in the returns you can get. Inflation may reduce the value of a currency, while high activity in the stock market may increase your assets' value. Keeping these points in mind, understanding TVM will benefit you greatly in your financial decisions. 

Saving More through the Time Value of Money

To fully appreciate the time value of money, it's best to see this concept in action. Consider this simple case:

• You put P100,000 in a bank account that earns you 1% interest annually for five years.
• After one year, you will have 100,000 + (100,000 x 0.01) = PHP 101,000.
• After two years, you will have 101,000 + (101,000 x 0.01) = PHP 102,010.
• After three years, you will have = 102,010 + (102,010 x 0.01) = PHP 103,030.10.
• After four years, you will have = 103,030.10 + (103,030.10 x 0.01) = PHP 104,060.41.
• At the end of five years, you will have = 104,060.41 + (104,060.41 x 0.01) = P105,101.01.

This should give you a better idea of how compounding interest can make your money work for you. While spending on your wants isn't necessarily a bad thing, you should always look at the bigger picture. If you're spending P100,000 yearly for temporary wants, imagine the number of savings opportunities you're missing out on.

Instead of draining your money aimlessly, look for stable investments and build a strong portfolio. Understanding your risk profile and how it lines up with your financial capabilities should help you identify which financial instruments are perfect for you.

3 Tips to Apply This Concept to Your Savings

1. Adopt a saving over spending mindset.
   According to Warren Buffet, "You shouldn't save what is left after spending, but spend what is left after saving." In simple terms, you should always set your savings aside before you make any expenses. Unfortunately, many people do the opposite or aren't able to do so for many reasons, like negative spending habits.
   
   Once you receive your monthly income, the first thing on your mind would be to pay for utilities such as food, rent, and electricity. After settling all your balances, what should you do with the remaining sum? Should you set everything aside immediately or wait to see what's left at the end of the month?
   
   The truth is, most do the latter and end up with nothing to save. Spoiling yourself from time to time isn't bad, but failing to practice restraint will end up compromising your long-term comfort. Buying a VUL insurance plan or investing in a mutual fund before you spend will ensure that your expenses are cut down and that your finances grow through the years.
   
   
2. Keep the rule of 72 in mind.
   Whenever you invest, you'll need to know how long it will take for your asset to justify your expenses. While financial programs can give you a precise estimate, calculations such as the rule of 72 will provide you with a quick and easy fix.
   
   The rule of 72 is a mathematical formula for estimating how long it will take your investment to double in value. It follows this simple equation:
   
   Years for Your Capital to Double = 72/Interest Rate
   
   For example, if an investment plan has an annual interest rate of 7%, it will take around 10.2 years (72/7 = 10.2) to double the money you've placed. While this formula may give you a fast answer, always remember that the result is only a rough estimate. All things considered; you can use this to compare different investment options.
   
   
3. Minimize installment payments with high-interest rates.
   Apart from helping you save, TVM can also improve the way people approach debt. Credit card users or those who've applied for loans should understand that compounding interest will work against their favor. Failure to settle financial obligations early on may cause them to walk a financial tightrope because the amount they owe can increase over time.
   
   As a rule of thumb, choose to make one upfront payment whenever you purchase. Installment plans and loans can look like they're giving you more flexibility, but if you're unable to pay on time, the incurring interests will end up costing you more.