The time value of money represents how much more valuable one dollar will be tomorrow than it is today.
It’s a bit more complicated than that (as we’ll see), but for now just understand that real estate investing follows this same principle—and investors all too often forget it.
Thanks to inflation, prices today are lower than the prices will be tomorrow. If your retirement savings consists of a mattress stuffed with cash, you are losing value by hanging onto your money.
Investing in real estate can help you maintain the value of your money over time and protect against inflation.
The time value of money is a financial principle that states that if you have money now, it's worth more than that same amount in the future. This principle has to do with interest rates and inflation. By saving now, your funds can either grow over time, or you can hold them as cash to protect them.
According to Rehab Financial, a private money lender, the time value of money formula is FV = PV(1 + r)ⁿ.
Here are the components of the time of money formula:
Formulas like the one from Rehab Financial can help you determine how much you must invest today to achieve a specific future amount. However, their accuracy may be affected by how much the market value fluctuates over time. Here’s how the value of money changes based on time:
In the U.S., the long-term inflation rate is roughly 3%. Because of inflation, $1 this year would only be equivalent to $0.97 next year. Inflation raises the price of goods, meaning you have to spend more money to get the things you need. When your savings do not grow at the same rate as inflation, you are actually losing the value of your money.
Risk directly correlates to the time value of money. If you receive the money today, then you will have that money and know it is there. If you put off receiving it until the future, you do not have that money and cannot use it for anything, nor do you know if you will receive it if something happens to prevent you from getting it.
One key aspect of money is investment potential. Having money now means you can reinvest the money into something and potentially end up with more money in the future. If you wait to receive the money, you cannot invest it, and the amount will remain the same. Having $100 today means you could invest it and potentially have $200 by next year rather than just waiting to receive $100 next year.
Where there is potential for a return on your investment, it’s usually better to invest the money you have now at its greatest time value and allow it to grow exponentially for the future.
With the time value of money, you can look at compounding and discounting to determine whether it is better to spend now or invest later. Do you want to wait for your money to grow or do you give up some of your money today for more tomorrow?
Compound growth is when you invest money today, expecting it to increase at an interest rate. After it increases, the next increase is then based on the initial price and the first increase. If you buy a home for $100,000 and expect it to increase in value 3.5% a year, after one year, it would be worth $103,500. After two years, it would be worth $107,122. The $3,500 that it increased after the first year adds to the 3.5% increase. When an investment accrues value this way, it is called compounding.
Discounting is when you convert the value of something you’ll receive in the future to determine what it would be worth if you had it right now. It can be viewed as the inverse of compounding because you are figuring out how much a future value is worth today rather than how much a current value is worth in the future.
For example, if you were to receive $1,000 in a year and expected an inflation rate of 10%, that $1,000 is currently equivalent to $909.09. To plan accordingly, you would see what you can do with $909.09 today to find out what you can do with $1,000 next year.
Property Metrics has many formulas that can be used to calculate this, but these are concepts you'll want to master because they will pay off for years into your future.
Imagine that you had $500 to invest at 5% interest for 10 years as a real estate investor. You can figure out the amount of money you will have at the end of the 10 years if you move ahead with the investment.
If FV = 500(1 + 0.05)¹⁰=$814.45, then investing the money for 10 years results in an extra $314.45 at the end of the period.
Real estate can appreciate much faster than money invested since prices for goods can increase even in times of low inflation. You have to factor in your own income taxes when deciding whether to borrow money, use your own money, or do both. When you calculate the internal rate of return of your real estate investments, understanding the time value of money can help you determine if it’s a good time to invest your money in a property.
Are you looking for ways to protect your real estate investing business? Learn about how to keep your assets with our investor quiz.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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