Taking steps towards financial wellness starts and ends with educating yourself, especially when it comes to financial concepts. All you need to do is a quick search on Google, and you’ll find information on a wide array of finance topics, from basic to complex.

One of the most fundamental financial principles you’ll need to learn is the Time Value of Money (TVM). Not only is it considered the backbone of wise financial decision-making, understanding it also empowers individuals to make informed choices, build wealth, and secure a prosperous future. It is also considered the crux of financial accounting and business decision-making.

Here’s a quick guide on what TVM is, how to calculate it, and its significance so you can start laying the groundwork for your financial literacy.

What is the Time Value of Money?

What if someone told you that the peso coin in your pocket today would be worth more in the future? The time value of money states that the savings you have now can increase in the future due to their potential earning capacity. Simply, it means that a sum of money now is worth more than its future value. Time value of money teaches you that the peso in your pocket is more valuable because you can use it, invest it, or save it to earn more over time.

How Does It Apply to Me?

Whether you are an investor or simply starting a savings account, money that you invest or deposit will earn interest. Over time, the interest on your initial investment will earn more interest, also known as compounding interest, earning more value since it has a longer time horizon. If you are taking your time investing money, there is an opportunity cost at hand. If it is not invested, money will eventually lose its value.

For example, let's say you have a deposit account with a 5% annual interest rate. If we deposit only ₱20,000 today and leave it for ten years, the account will have a higher value than if we made a larger deposit of ₱25,000 but only kept it for five years.

Economic factors and trends may also play a huge part in the returns you can get. Inflation may reduce the value of a currency, while high activity in the stock market may increase your assets' value. Keeping these points in mind, understanding TVM will benefit you greatly in your financial decisions.

[H2] How to Calculate Time Value of Money

Whether you’re saving for the future or considering an investment, learning how to calculate TVM helps you understand the value of your money in the future or today. For simplicity’s sake, you can use a formula in Microsoft Excel or Google Sheet to calculate TVM.

To fully appreciate the concept, it's best to see it in action. Consider this simple case:

You put ₱100,000 in a bank account that earns you 1% interest annually for five years.

After one year, you will have 100,000 + (100,000 x 0.01) = ₱101,000.

After two years, you will have 101,000 + (101,000 x 0.01) = ₱102,010.

After three years, you will have = 102,010 + (102,010 x 0.01) = ₱103,030.10.

After four years, you will have = 103,030.10 + (103,030.10 x 0.01) = ₱104,060.41.

At the end of five years, you will have = 104,060.41 + (104,060.41 x 0.01) = ₱105,101.01.

This should give you a better idea of how TVM can make your money work for you, or help you decide whether an investment is worth pursuing. While spending money on your wants isn't necessarily a bad thing, you should always look at the bigger picture. If you're spending ₱100,000 yearly for temporary wants, imagine the number of savings opportunities you're missing out on. Remember, any amount you put into a savings account eventually earns interest and later on, interest on top of that. Therefore, the longer your money is invested or saved, the more time it has to benefit from compounding interest.

Instead of spending without purpose, seek stable investments and build a strong portfolio. Also, take the time to understand your risk profile so you can understand yourself as an investor. The more financial knowledge you have, the more empowered you are to make informed choices, construct a resilient portfolio, and start a financial journey that is in line with your goals.

How to Apply TVM to Your Savings

Applying the Time Value of Money principle to your own savings is a strategic move that can help maximize the growth of your funds over time. Here are 3 ways to incorporate TVM into your saving strategy:

Adopt a saving over spending mindset

According to Warren Buffet, "You shouldn't save what is left after spending, but spend what is left after saving." In simple terms, you should always set your savings aside before you make any expenses. Unfortunately, many people do the opposite or aren't able to do so for many reasons or have poor spending habits.

Once you receive your monthly paycheck, the first thing on your mind would be to pay for utilities such as food, rent, and electricity. After settling all your balances, what should you do with the remaining sum? Should you set everything aside immediately or wait to see what's left at the end of the month?

The truth is, most may do the latter and end up with nothing to save. Spoiling yourself from time to time isn't bad, but failing to practice restraint will end up compromising your long-term comfort. Opting for a VUL (variable universal life) insurance plan or investing in a mutual fund before you spend may ensure that your expenses are cut down and that your finances grow through the years. If you’re an individual who is looking to invest in a profitable venture, choosing VUL may benefit you more. Its approach allows you to build your investment assets, creating a cash value for your policy over time. You can learn more about VUL here.

Keep the rule of 72 in mind

Whenever you invest, you'll need to know how long it will take for your assets to justify your expenses. While financial programs can give you a precise estimate, calculations such as the rule of 72 will provide you with a quick and easy fix. The rule of 72 is a simple but powerful financial concept that could be a game changer in wealth-building.

The rule of 72 is a mathematical formula for estimating how long it will take your investment to double in value at a fixed annual rate of return. You divide 72 by the annual rate of return and you get the approximate amount of years it takes for your money to double. It follows this simple equation:

Years for Your Capital to Double = 72/Interest Rate

For example, if an investment plan has an annual interest rate of 7%, it will take around 10.2 years (72/7 = 10.2) to double the money you've placed. While this formula may give you a fast answer, always remember that the result is only a rough estimate. All things considered; you can use this to compare different investment options.

Knowing the doubling time of your investments allows you to plan strategically for financial goals. Whether you’re saving for a downpayment for your future home, funding your child’s college education, or building a retirement nest egg, understanding how quickly your investments grow helps you set realistic deadlines.

Minimize installment payments with high-interest rates

Apart from helping you save, TVM can also improve the way people approach debt. Credit card users or those who've applied for loans should understand that compounding interest will work against their favor. Failure to settle financial obligations early on may cause them to walk a financial tightrope because the amount they owe can increase over time.

As a rule of thumb, choose to make one upfront payment whenever you purchase. Installment plans and loans may look like they're giving you more flexibility, but if you're unable to pay on time, the incurring interests could end up costing you more.

Now that you understand the basics of TVM, you’re well on your way to making better financially informed decisions. You now have the foresight to make investments that will resonate with your goals. Also, life can be unpredictable, and your financial goals may evolve. Arming yourself with financial knowledge will help set the stage for long-term financial success and security.

If you’re looking to learn more about finance and investing, spend a few minutes each day on BPI-AIA's library of articles on its website. Take advantage of a wealth of information on building wealth to working abroad and beyond. Give yourself the gift of knowledge and visit BPI-AIA's website today.