How the Time Value of Money Can Impact Your Net Worth
A dollar is a dollar no matter when you earn it, right? Turns out, that’s not exactly the case.
And when you’re working to build your net worth, that makes a huge difference as the years go by.
Here’s a look at how time and net worth can work together, and how you can make the time value of money work in favor of your net worth.
What is Net Worth?
Net worth is the total value of a person or company. It’s not to be confused with what you earn in a year—this is the total amount of money that you’re worth, your total assets minus your total liabilities.
When your assets are greater than your total liabilities, you are said to have a positive net worth. Conversely, if your total liabilities are higher than your total assets, you have a negative net worth. This is often the case for people who have outstanding debt, such as a mortgage, car payment, or student loans.
And because it gives a basic snapshot of whether you’re in the red or in the black, it’s a useful metric for understanding your overall financial health. Ideally, you should have a positive net worth—the bigger, the better. For most people, this boils down to what your life will look like once you stop working and what you’ll leave to your children, since you begin chipping away at your net worth and assets once you stop working.
Keep in mind that because your assets and liabilities evolve over time, your net worth changes with them. Part of the goal of investing is to boost your net worth as much as possible (and as sustainably if possible).
Calculating Net Worth
Net worth is easy to calculate—just subtract your total liabilities from your total assets. Thus:
Net worth = total assets – total liabilities
An asset is any resource of economic value that an individual, company, or organization owns or controls with the expectation of a future benefit. Most people’s assets include things like their home or car, but it also includes the value of your investment assets.
A liability is a financial obligation to another party which has not yet been paid for or completed. It’s any financial obligation that depletes your resources, such as a mortgage, car loan, student loan, credit card debt, medical debt, and so on.
If you’re financially healthy, your liabilities should be fairly minimal, and your net worth should be positive. Because many people have limited resources and have to take on liability to afford things like a house or car, it may take a while to reach a positive net worth. Your investments can help you get there.
What is the Time Value of Money?
This brings us to the time value of money, a basic financial concept which holds that money in the present is worth more than the same sum of money received in the future. That’s because the money you receive today has the potential to grow—for example, if you invested and earned a return on the money. Plus, future money carries the risk that the money may never be received, since you don’t know what might happen in the future.
If that sounds counterintuitive, it helps to imagine the time value of money in action.
Let’s say someone offered to pay you $100 now or $110 in a year. The right pay option depends on your expected investment return if you took the money now. If you’re confident you can earn at least a 10% return by investing the money the right way, it’s worth taking the money now. If not, you’re better off accepting the same value in a year, when you can use it for better returns…as long as you trust that the payee will give you your money in a year’s time.
Calculating Time Value of Money
The formula to calculate the time value of money varies depending on the situation. In most cases, the formula accounts for variables like present value, interest, compounding interest, compounding periods per year, and the number of years. A good basic formula looks something like this:
Future value of money = present value of money x [1 + (interest rate/number of compounding periods per year)] ^ (number of compounding periods per year x number of years)
You should also keep in mind that the time value of money is also tied to inflation and purchasing power. A dollar today isn’t worth as much as a dollar in ten years and advanced calculations account for that. For now, though, you can stick to the basic formula as a reference point.
How Time and Net Worth Work Together
If this sounds like a hypothetical exercise, remember that investing is all about growing your money with the available information. Your ultimate goal is to grow your net worth. But the time value of money influences those calculations because it changes your understanding of value and the best possible investment decision.
By adding the time value of money into your calculations, you can get a better estimate of what performance you would need to see to achieve your investment goals. It also gives you a better understanding of your options. If you know how to calculate correctly, that ultimately shakes out in favor of your net worth.
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