Because money deposited or invested can earn more money over time, time can allow the value of money to increase. Time also has the effect of eroding the purchasing value of money through inflation. You can use certain financial calculations, described later, to estimate what effect time might have on your money.
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Albert Einstein once said, “The most powerful force in the universe is compound interest.” Not only can your dollar earn interest over time, but the interest itself can earn interest, known as compound interest. If you were to graph the results of compound interest on a chart, you would see a parabolic curve showing that even the rate of increase increases over time.
You can see an example of this effect in a comparison of two people’s retirement savings. One saves $2,000 per year for 10 years beginning when he’s 25 and quits after setting aside $20,000. The other saves $2,000 per year for 30 years beginning when she’s 35. At age 65 the man has $255,018, assuming 7 percent interest compounded each year, but the woman has nearly $38,000 less, in spite of having saved three times as much.
When you understand the potential future value of a sum, you can use this information to “discount” a present sum of money compared with a larger sum to be paid in the future. This explains why some retailers will offer customers a discount if they pay the entire amount due up front. The retailers understand that money in hand today might be more valuable than a larger sum paid over time.
Net Present Value
Another way to look at the time value of money is to convert or “discount” a stream of future payments into one lump sum received today. If you won the lottery, for example, you could use the “Net Present Value” calculation (see Resource section) to decide whether you want the smaller lump sum today versus a stream of payments over the next 25 years. Investors also use this type of calculation to estimate the purchase price of a business based on its expected future earnings.
When you review your retirement savings, you want this calculation to go the other way, and figure out how much you can pay yourself each year. The “annuitization” calculation assumes that the money left after you take a portion each year still earns compound interest, increasing the time over which you can withdraw funds. Of course, this type of calculation does not take inflation into account, which also compounds over time.
Understanding the effects of time on your investments allows you to make better financial decisions. However, unless you know how to use a financial calculator, calculations such as these can be difficult to do on your own. See the Resource section for some Web-based financial calculators that will allow you to play with the calculations described earlier.
In addition, bear in mind that if time really does increase the value of your money, then there's no time like the present to pay down your debts and increase your retirement savings.