Why time value of money is important in financial planning

time value of money, financial planning, demonetization , FD, Recurring Deposit, RD, starting early

Time can wreak havoc on your profits, savings, and personal wealth, if due care is not undertaken.

If you thought demonetization was a big game-changer and destroyed the value of money in huge chunks, there’s a bigger game-changer on the horizon. This game-changer dwarfs demonetization when it comes to eroding the value of money. It is called time.

Time can wreak havoc on your profits, savings, and personal wealth, if due care is not undertaken. The most dangerous aspect of this is that erosion of your wealth over time can happen without you even knowing it. However, if you take timely investment decisions, time can work for you.

In order to see what corrosive impact time can have on your money, let us first understand the concept of ‘time value of money’.

Time value of money decoded

Time erodes the value of money since what money can buy today, it can buy lesser tomorrow. Let us say you have a hundred-rupee note in hand today. Assume you can buy a basket of vegetables with that money. If you keep this cash with you for a year, and try to buy the same basket of vegetables a year later, you won’t be able to buy them.

This is because the vegetables would have appreciated in price. Chiefly, this may happen due to either higher demand for these vegetables or an increase in prices due to lower supply of these vegetables. This price rise is known as inflation.

The purchasing power of your hundred rupees has decreased over a year’s time, since now you need to shell out more to purchase the same basket of vegetables. So, if the same basket of vegetables costs a hundred and five rupees after a year—an inflation of five percent—your money needs to earn five percent per year just to keep pace with inflation and not lose value.

Erosion of the value of money over time is also because of the uncertainty of future. A hundred rupees now represents some certainty in what you can buy with that money. On the other hand, in future anything could happen to decrease or nullify the purchasing power of your hundred rupees in hand—you may misplace your money, the national economy could collapse, or prices of goods could skyrocket. Or, your hundred-rupee note may get demonetized and you are not able to exchange it at the bank for some reason.

The concept of compounding over time

If you need to stop time from corroding the value of your money, you need to start making it work for you. You do this by “starting early” and “investing smartly”. Let us say you have a sum of Rs 1 lakh in your savings account, kept aside for your son’s school fees in six months’ time. Remember, anything that gives you a return lesser than prevailing inflation is actually causing you to lose money, so money in a savings account usually represents a loss.

So, you need to move your Rs 1 lakh to an investment whose returns far exceed inflation but also mature in six months’ time. You can opt for an Fixed Deposit (FD) with a term of six months with quarterly compounding, wherein the principle plus interest at the end of the first quarter is reinvested at the same rate of interest, so you earn interest on interest. This is the compounding power of time.

However, the compounded returns after six months may still not be able to beat inflation. In such cases, you can unleash the full power of compounding by opting for a FD of longer maturity period, say two or three years, where the returns are the highest in its class.

To deal with the school fees, you can park a part of a regular income like monthly salary in a flexible Recurring Deposit (RD) for a term of six months. The returns here, like the six-month FD, will be definitely lower than that of the two-year FD—but you are not parking your entire Rs 1 lakh at this (lower) six-month interest rate. You are doing it in instalments, which brings down the average principle amount parked at the (lower) six-month interest rate.

When it comes to investment and financial planning, have time on your side by starting early and investing smartly in order to avoid the corrosive effects of time.

[“source=financialexpress”]