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How To Calculate The Future Value of Money?

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How To Calculate The Future Value of Money?
"Time is money", chances are very high that you may have heard these words very often.

“Time is money”, chances are very high that you may have heard these words very often. It might have been used in different terms but, Future Value of Money when you consider this in financial terms, the time frame is very critical in this matter. Now, it is doubtless that we invest money with one core purpose, and that is the return on that investment. There are some other factors that we consider that is investment growth, return rate, profit’s interval, etc. but, there are other factors which should be considered while investing. Suppose, if you are investing something and you are expecting a certain amount of return, then, you should also be aware of the fact that what importance that money will hold in future? What will be its purchasing power then? Still, confused? Let us take a look at this example.

Imagine, you have $100 today, and you are going to invest it for five years, and after five years, you will get $120 ($100+$20). Here, $20 is the amount of profit you earned. Now, you must ask yourself, will that $120 have same purchasing power after five years as those $100 have today? It means if you can purchase a certain commodity for $100 today, can you purchase the same commodity for $120 after five years? If yes, then, your investment is keeping up with the inflation rate. If no, then your investment return is not good enough. Purchasing power and inflation are the two important factors that need consideration while investing.

Thus, the time value of money can be explained as strength or purchasing power of money in a given time period. Let us take another example to make it clearer. Assume, someone is offering you $2000 for a specific task now, and the other option is you can get $2200 for the same task but after two years. Now, generally speaking, $2200 looks way more than $2000. But, you need to know what value those $2200 will possess after these two years. Also, you need to evaluate, if you get those $2000 today and invest them somewhere, can you covert those $2000 into $2200 or more? If yes, then go for “$2000 now” option. If not, then settle for “$2200 after two years optionTimes Values .

Future value of money

When we talk about the value of money, investments and their return rate. It is understood that we are talking about the future value of our money or investment, as discussed above. Future value can be simply described as “value of a current investment or an asset at some future date while keeping the growth rate in mind”. Assessing the future value of any investment is not only important for individuals but, it is also very important for businesses because it helps companies to evaluate the benefits of a certain investment they can get. This makes the decision making a lot easier for these organizations.

Future value explained
Future Value Calculation Serves Different Purposes For The Investors.

Future value explained

Future value calculation serves different purposes for the investors. For example, it can help investors to predict the variations in the overall accuracy. It can assist the investors in estimating the amount of profit that can be generated in the future and what is the potential for growth related to a certain investment. It is also used to compare multiple investment options also.

However, calculating the future value is not that easy. It varies according to the nature of the asset. For example, if you are investing in a saving account with a guaranteed return on your investment, then, calculating the future value of the investment you made will be way lot easier. But, if the investment is related to stocks and shares and you are calculating its future value, then, this value calculation will be a lot more complex as compared to the other one. That is because the stock market is way more volatile and unpredictable.

Before moving towards the calculation of the future value using different types, let us talk about two major factors (purchasing power and inflation) that can affect these calculations.

Purchasing power and inflation

You simply cannot make optimal calculations as far as the value of money is concerned, unless, you have considered the inflation factor while doing that. The inflation rate is directly linked to the purchasing power or value of the money. If your investment return rate is lesser than the inflation rate, your investment is not good enough. For example, if the return rate on your investment is 5% per year and the inflation rate is 7% per year, then, your investment is actually costing you money. Therefore, these factors must be considered while making these decisions.

 

Calculating the future value using the simple interest method
Calculating The Future Value Using The Simple Interest Method.

Calculating the future value using the simple interest method

Future value of the money can be calculated using two most common methods, and one of them is using the simple interest rate method, but there are few assumptions that are made while calculating the future value using this formula:

  • The growth rate for that certain investment is held constant.
  • The amount of investment remains the same in that period (nothing is withdrawn during that period).

Formula to calculate the future value using this method is:

Here:

FV= future value

I= principal amount or the total investment

R= interest percentage

T= time period (total number of years)

Let us make it easier with an example:

Assume that you are going to invest $2000 for a time period of 5 years and the return or interest rate is 15 percent,

then, at the end of five years, the net value of the amount will be $3500 by using this formula.

FV= $2,000 × [1 + (0.15 × 5)] = 3500

How to calculate the future value with compounding interest method

While using simple interest formula, the rate is implemented on the principal or initial amount but in case of this compound method; the rate is implemented on the cumulative or total balance of an account. For example, in the above example, the total amount of interest earned in five years was $1500, and if it is divided by five years, then, annual interest was $300. The rate was applied to the principal amount, $2000 every year Investopedia.

But, when we use the compound interest model, the rate is implemented on the cumulative amount after each period. For example, keeping the above example in mind, the net account balance after one year will be $2300 ($2000 principal amount +300$ interest for the first year). If we are using the compound method, the interest rate at the end of the second year will be applied on $2300. It will not be applied to the initial principal amount ($2000), and this will go on like this.

Here is the formula to calculate the value:

Here:

FV= future value

I= principal amount or the total investment

R= interest percentage

T= time period (total number of years)

Now, if we take the same values used in the previous example, then, using this formula, the total value after five years will be.

FV= $2,000  [(1 + 0.15)5] = $4022.71

Now, it is evident that this formula does not account for inflation factor or purchasing power factor which cannot be neglected in practical terms. So, these values are obtained with certain assumptions. But, the question arises, how can this activity help the investors? The answer to that is very simple.

You are going to invest, so you need to calculate the future value. You can calculate the future value by using this formula. Then, you can see the inflation rates trend for the past few years and can estimate how inflation rates will operate in future. Now, adjust the inflation rate with the interest rates. If, interest rate still outplays the inflation rate, then, your investment is categorized as a good investment. But, if it is not, then you are actually going to lose money.

The bottom line:

No one has foreseen the future, and you cannot predict economic or natural disasters that may occur in future. But, using past trends, you can forecast what is going to happen in future and calculating the future value of your investment will definitely help to analyze things and make profitable financial decisions. 

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