The Real or Time Value of Money

The time value of money is one of the cornerstones of the financial services industry and indeed the investment community.

In relation to personal financial planning, accumulating funds to cover future needs is a constant topic. These needs can be providing Life Assurance cover to provide for dependants, saving to grow a capital sum or perhaps investing a lump sum to grow and be drawn down in the future.

It is important to understand that the value of a  Euro changes over time, a Euro invested today will accumulate over time with interest to amount to more than a Euro. Due to inflation, a Euro in 20 years will be worth less than a Euro today, that means the goods and services you can buy today with your Euro will cost more in 20 years.

Think about the penny sweets you could once buy versus what you get for a penny today, or indeed anything you could buy for a certain sum versus what it costs today.

So when assessing a future financial need allowance should be made for anticipated inflation in order to allow for the “time value” of money.

For example, if your projected pension in 20 years is valued at €35,000 pa, allowing for a 3% anticipated inflation over the next 20 years, this will equate to €19,380 pa. in today’s terms. If we increase the inflation rate to 5%, the value will be €13,190 pa in today’s terms.

Inflation has a significant effect on the “real value” of money in relation to savers and investors. Most savers and investors will want (as a minimum) objective, to at least maintain the “real” value of their money after allowing for inflation, if the interest rate payable does not surpass the inflation rate.

The real value of their capital, in terms of purchasing power, will decline.  Inflation can be “good news” for people with substantial borrowings,  as it can gradually reduce the real value of the repayments and the scale of the debt itself. On the other hand, deflation is bad for borrowers, as the real value of the repayments and amount owed increases.

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