Time Value of Money

Time Value of Money

The time value of money relates to many activities and decision in the financial world. “Understanding the effective rate on a business loan, the mortgage payment in a real estate transaction, or the true return on an investment depends on understanding the time value of money” (Block, Hirt, 2005). The concept of time value of money helps determine how financial assets are valued and how investors establish the rates of return they demand. Many different types of companies use the time value of money, such as commercial banks, credit card companies, insurance companies, retirement advisors, and the state government. As an individual or company, the importance of understanding how each of these company’s services can affect ones overall cash position is very important.

When determining the “future value, we measure the value of an amount that is allowed to grow at a given interest rate over a period of time” (Block, Hirt, 2005). When determining the present value one would reverse the method for calculating future value. Future value and present value calculations may also deal with annuities rather than single amounts, “which may be defined as a series of consecutive payments or receipts of equal amount” (Block, Hirt, 2005).

Financial Institutions use the time value of money concept in many different methods. One method of using time value of money is to calculate the money earned from an interest bearing savings account.

Interest bearing accounts typically compound interest on a daily or monthly basis on the balance in the demand deposit account. When interest is compounded the balance continually grows with the credited interest therefore, using the time value of money using the future value concept. A dollar invested today is worth more than a dollar invested tomorrow even if the amount is only a dollar. Not investing money into an interest bearing account and just hiding the money under one’s mattress would be at the present value because nothing was earned.

Credit card companies, such as Capital One, charge the business or individual an interest rate, typically high, to borrow money for current transactions. Most credit card holders pay back only the minimum payment due, which primarily goes to interest and very little to principal. “The minimum payment drops as your balance is paid, but thanks to the magic of compounding, you'll end up paying for a long, long time” (Bankrate.com, 2008).

Credit card payments are considered an annuity or stream of payments because they are paid over time. One would need to determine the future value of an annuity to determine how much long and how much interest will be paid by paying only the monthly payment as oppose to increasing the amount slightly each payment. The result will show that making a slightly higher payment will allow the borrower to pay off the debt sooner and by paying less interest overall.

Many types of insurance companies are available to consumers, such as life insurance providers. An individual can determine how much life insurance will be needed by using the present value equation because that will determine what money payable in the future is worth today at a given rate of interest. The formula used to compare costs of life insurance is known as the interest-adjusted cost index which “converts the time value into a dollar figure. According to this formula, which can be computed by companies and salespeople for their policies and given to prospective buyers,