Time. You cannot hold it. You cannot see it. You cannot stop it.
But… you do have a choice. Utilize it or don’t.
When it comes to planning and building wealth (or for anything) – time matters. And, compounding most certainly does too. 1
Time Value of Money
These two concepts are both fundamental, foundational and most certainly essential. The sooner you learn them and the sooner you apply them – the better off financially YOU WILL BE!
Whether you realize it or not, time and compound interest are powerful. Time allows for potential. Compounding allows for growth. Both concepts are simple, so let’s analyze why time and compound interest matter.
What is Time Value of Money?
Time Value of Money. You may have never drawn the comparison that time and money have a mutualistic relationship - it does. Money not only has a monetary value; it has a time value too. Let’s look at a quick example:
You completed a service for a client, and you are owed $10,000 dollars. The client calls you to let you know that he is ready to give you a check for the bill. He gives you a choice to swing by his house to collect the $10,000 before he goes out of town for a month. You have a choice. Do you wait for a month or do you go by his house to collect what he owes you?
Some may say it doesn’t matter as long as they get paid, but time value of money says it does matter. Why? Because receiving money today is worth more than receiving that same $10,000 dollars at any given point in the future. Yes, even if you had the option to receive it tomorrow. Your money has potential earning capacity. This means that the $10,000 you received today; you have the potential to earn money on that $10,000 today. So, if you took the $10,000 a month from now instead of today, you would miss out on all the potential earning capacity of each day you did not have the funds.
• If you receive the money today – you can make money on your money today.
• If you receive the money tomorrow or at any given point in the future but had the option to receive the money today – you lose out on the potential earnings of today and every day in the future that you delay receiving the money.
What is Compound Interest?
Formula: FV = PV (1 + r)^n
(FV): Future Value
(PV): Present Value
(r): Interest rate earned per year (%)
(^): Exponent – the number of times a number is multiplied by itself
(n): Number of periods
Said to have been described as “the eighth wonder of the world” by Albert Einstein, compound interest can be simplified from the formula above. Yes – FV, PV, R, and N are each important in making your money grow, but where you capture the most growth is often the most overlooked piece of the formula. The “upside-down v” or exponent allows for compounding. It allows you to exponentially grow the present value (PV) to a greater future value (FV). To get from PV to FV the compound interest accrues - this means that not only will you earn interest on the principle (initial amount), but also you will earn interest on your interest.
Yes, you read that right. You can earn money on the money you’ve earned.
Let’s take the previous example above and say you decided to swing by your client’s home to receive the payment of the $10,000. Let’s also say you immediately took those funds to the bank and put it in a savings account. It also turns out that the savings account at your local bank is yielding 10% (for simple math – FYI, most savings accounts yield less than 1% unless it’s an online bank). Here’s what that would look like if you deposited the $10,000 and did not touch the funds for the following years:
Year One: $10,000 x (1+0.1) = $11,000
Year Two: $1,100 x (1+0.1) = $12,100
Year Three: $1,210 x (1+0.1) = $13,310
Year Four: $1,331 x (1+0.1) = $14,641
Year Five: $1,464.1 x (1+0.1) = $16,105.10
Year Ten: $1,610.51 x (1+0.1) ^5 = $25,937.40
Year Twenty: $2,593.74 x (1+0.1) ^10 = $67,275
After year one, you would have made $1,000, because you earned 10% on your principal ($10,000). In year two you would have earned $1,100, because you earned 10% on your principal ($10,000) and the interest you earned from year one ($1,000). This is what compounding looks like.
How does time value of money and compound interest work together?
In the compounding example above, let’s assume you put the $10,000 under your mattress for ten years, then decided to put it in that same savings account that was offering a 10% yield. Instead of turning your $10,000 into $67,275, your $10,000 would only be worth $25,937.40. This is due to the fact that you decided not to make the choice to utilize time, you would have lost out on $41,337.60. That’s why time matters and coupling it with compound interest amplifies its importance.
• Money grows, but you must have it to receive the potential of growth. If given the option, ALWAYS take the money NOW.
• Compound interest is perhaps the 8th wonder of the world. You can earn money on the money you’ve earned.