Today we will talk about the concept of the time value of money: what types there are, which advantages and drawbacks it has.
Moreover, we will discuss what we need to know to calculate the value of money in the future. In the article, you will find not only the calculation formulae but also understandable examples explaining all the details and a ready-made instrument – a calculator of future money value.
What is future value
As early as the Middle Ages, people noticed some correlation between money and time. There exists a concept of time value of money. By this concept, the sum made today has more value than the same sum received tomorrow. The idea is based on the possibility to get some income over a certain timeframe after investing your money under some interest.
Current value is the cost of the asset today, and potential value over a certain timeframe plus interest is called the future money value. To calculate this parameter, you need a formula.
However, it must be noted that calculation of future money value may differ in different situations. If your asset is on a savings account with a guaranteed interest rate, its value in the future is rather easy to calculate. However, if we take a look about stock market investments with unstable profitability, calculation will be complicated because of certain extra parameters.
Moreover, calculations usually neglect inflation and other factors that have negative influence over the asset price.
What types of future value there are
The main classification is based on interest calculation:
- Simple interest calculation implies constant speed of growth and one payment in a certain investment period.
- Complex interest calculation is applied to the total balance of all investments over certain time. The investor makes money not on the initial investment but on the whole account balance.
How to calculate future money value with simple interest
If you have your doubts about the calculator of future money value, you can use the formula of calculating future value with simple interest:
FV=I×(1+(R×T))
I is the sum of investment
R is the interest rate
T is the total number of years in the investment period.
Example of calculating future money value with simple interest
Imagine you decided to open a bank deposit of 10,000 USD under the annual interest of 10% for 3 years. The calculation will look like:
FV=10000×(1+(0,1×3)
The future value of your investment will be 13,000 USD.
How to calculate future money value with complex interest
Using simple interest means that the interest rate is charged on the initial investment only. With complex interest, the interest rate will be charged on the whole account balance over each investment period.
The calculation formula with complex interest looks as follows:
FV=I×(1+R)T
I is the sum of investment
R is the interest rate
T is the years in the investing period
Example of calculating future money value with complex interest
You have the same 10,000 USD from the previous example and still want to deposit them on a banking account under the interest of 10% a year for 3 years, yet under different conditions. The calculation will look as follows:
FV=10000×(1+0,1)3
The future value of your money will be 13,310 USD.
How to calculate future value of annuity
If an investor plans to invest a certain sum every month or year, calculation of the annuity future value will help to understand how much they will have in the end.
The formula of future value calculation looks as follows:
FV=C×[((1+I)N−1)/I]
C is the sum of investment
I is the interest rate
N is the number of payments.
Example of calculating future value of annuity
Imagine your investment plan implies a series of 5 payments, 10,000 USD each every year under the interest of 10%. The calculation of the future annuity value will be:
FV=10000×[((1+0.1)5−1)/0.1]
The future annuity value will be 61,051 USD.
Advantages of calculating future value of investments
- Planning. An investor can forecast what happens to their money over a certain timeframe. For example, they can estimate how much time they will need to reach a certain sum on their account.
- Comparison. The calculations help the investor compare investing options to choose the best one.
- Availability. The calculation formula is rather easy to use and requires solving no complicated math problems. The investor only needs to know the sum of their investment, the interest rate, and the time the money will be invested for.
Drawbacks of defining future value of investments
- Limitations of the formula. Unfortunately, the formula for calculating the future value of money suggests constant growth only. As a rule, only the interest rate is used, without any further parameters, and if we add any, the calculation will become much more complicated. Moreover, in reality growth is not always linear.
- Probabilistic character. The calculation of the future value of investments is a supposition that may never come true. For example, a stock market investor may count on 10% of their investment returning annually. However, the market can change from the bullish to the bearish phase, so the return on investment will also change.
How to use calculator of future investment value
Choosing an investment option, you need to account for not only your goals but also the time they will take to be reached. Having a general idea of how much money and for how long you need to invest it, you can choose an optimum option. You can decide on a more serious risk when you have the resources or stay conservative when your resources are limited.
And to know the future value of your asset, you can use a ready-made instrument – a calculator of future investment value. Just put in your current data and push the button, and you will get the result.
Bottom line
The concept of the time value of money is an important part of personal money management. It perfectly demonstrates why money depreciates with time and helps to understand how much the money you invest today will cost, say, a year later.
Thanks to simple formulae and actual data about investment conditions you can easily define future investment value. This will help you make complicated financial decisions.
The post How to Calculate Future Value of Money: Formulae, Calculator, Examples appeared first at R Blog – RoboForex.