Many people have heard the phrase a penny saved is a penny earned. What happens to that penny over time?
The penny you save will not always be worth a penny. Sometimes it will be worth more or less than a penny. The value of the penny changes over time. The time is critical in the value of your money. The time value of money refers to the relationship between time, money, and the rate of interest.
For example, if you have $150 today and put it in an envelope to keep in your desk drawer, you would have $150 a year from now. Will you be able to buy the same item that you were saving for a year from now? You may not be able to, because the $150 you had put away will buy less than a year ago because of inflation. The rise in the cost of goods or services over time decreases the value of the dollar you have.
Suppose you put the same $150 into a savings account with an interest rate of 5% a year. Using the formula, you will see how much interest you will have a year later:
Interest=Principal x interest rate x time
$7.50=$150 x .05 x 1 year
After one year in your savings account, you will have earned interest and have a total of $157.50. There are three elements that the National Endowment for Financial Education mentions will help you reach your financial goals. The elements include the amount of money you save or invest, the rate of interest you earn, and the time is has to make new money. The time value of money really works when you look at the compound interest you are able to earn over time. This is the interest that you earn on interest over time.
Now, suppose you put $150 into an investment account that earns 8% a year--$150 x .08 = $12. If you add the $12 to the $150 you had originally, you now have $162 at the end of the year. If you want to see how much money you will have at the end of five years, you can use the following formula to calculate the compound interest:
A = P (1 + i)n
A is the amount of money in the account, P stands for principal and is the original amount invested, i represents the interest rate and is expressed as a decimal, and n is the number of years compounded.
With the above example of $150 deposited after five years, you will have a total of $220.40 in your account. To take full advantage of the time value of money, start saving and investing now. Your money will increase over time and will improve the chances that you will have it to meet your financial goals when you need it.