By Karl Shanholtzer, BTI

The time value of money may be thought of as the financial application of the old cliché “a bird in the hand is worth two in the bush”. This is based on the idea that money available today is worth more than the same amount of money at a future date due to its earnings potential. Several factors play a role in the time value of money calculation including interest, time, and even inflation.

Interest is the amount of money paid on an investment or charged on a loan. Interest may be calculated as either simple or compound. Simple interest is calculated based on a set rate and a fixed amount of money. Compound interest, however, is calculated by continually adding the interest earned back to the original principle and then calculating the interest again for the entire duration of the investment or loan. Interest works to increase the time value of money.

The length of time that an investment or loan is held also effects the time value of money. For example: when comparing mortgages, a 15 year mortgage on $200,000 at 4% would cost more per month than a 30 year mortgage at the same interest rate. However, the 15 year mortgage would save a homeowner more than $77,000 over the length of the loan.

Inflation is the third factor in determining the value of money over time. Inflation in its simplest form can be described as the increase in prices of goods and services over time. Because costs rise over time, a dollar a year from now will not buy the same amount of goods or services that it will buy today, therefore, inflation has a negative effect on the time value of money.

Time value analysis has many practical applications such as planning for retirement, valuing investments, and evaluating loan options. Always remember, however, a bird in the hand is usually worth more than two in the bush.