01 Mar The Time Value of Money (AKA, how to become a millionaire), Part 1
Welcome back to Investing for Beginners!
Now, let me ask you something. What’s the one thing we all possess, no matter who we are, and which is actually more valuable than money? The answer… is time. That’s because time is something we can never get back, unlike money. And what’s more, time is the key to a secure financial future.
Which brings us to our introductory lesson and the most important principle in investing: the Time Value of Money (TVM).
Simply put, the Time Value of Money means that a dollar today is worth more than a dollar tomorrow.
Let’s use an example. If I told you that I’ll either give you $1,000 now or $1,000 a year from now, which would you choose? You’d take the money now, right? And you should, but not because you’ll spend it all on your Amazon wish list. Instead, you’re going to invest it.
Imagine you put the $1,000 in your bank account which currently pays 2% annual interest. So after one year, your $1,000 would grow to $1,020. That’s because 2% of $1,000 is $20. But here is where it gets interesting. What happens if you let that money accrue interest for another year? How much interest would you earn in Year 2?
If you said $20, you’d be wrong. That’s because in Year 2, the 2% annual interest is applied to your principal (initial amount) of $1,000 and your $20 of interest earned in Year 1. So at the end of Year 2, instead of multiplying the 2% annual interest by the $1,000 you started with, you would multiply it by the $1,020 you had at the end of Year 1.
To calculate that, you’d write the equation $1,020 x 1.02, which gives us the amount of $1,040.40. In other words, when you applied the interest rate of 2% to Year 1’s final balance of $1,020, you earned $20.40 in interest in Year 2. That’s 40 cents more than what you earned in Year 1, when the 2% rate was only applied to your principal of $1,000.
Which brings us to the second-most important principle of investing: Compound Interest, which is when interest is applied to your principal and to your previously earned interest. Combined with the Time Value of Money, it’s Compound Interest that makes your money grow. And don’t think both of these concepts only apply to money in your bank account. They also apply to investing in stocks, bonds, mutual funds and ETFs, all of which will be covered on this blog in the future.
Remember: the sooner you invest, the larger your money will grow. And in the next blog post, you’ll see exactly why. Stay tuned!