Question

Explain the concept of time value of money in the context of simple interest. How would you use this in retirement planning? No copy and paste, thank you.

Answer 1

The time value of money means that the earning today is worth more than what will be earned in future as the money earned today can be reinvested to earn further income or interest. Time value of money is usually calculated with compounding interest. Simple interest does not consider the earning earned on principal and is calculated on principal only. Thus, time value of money is useful in context to simple interest as it considers the cash flow generated in future which simple interest doesn't.

Time value of money is useful in retirement planning as in retirement planning we used to calculate the amount to be invested in present to generate the specified income in future. In retirement planning we specify a certain income for future, thus we need to calculate today's investment required for the same for certain and consistent income in future. Time value of money help in calculating the present investment for specified future income considering the compounding interest on it.

For example, the present value of $5000 from one year from now at compounding rate of 6% will be

Present value = $5000/((1+.06)^1

= $4,716.98

Thus, investment of $4,716.98 will generate $5000 after one year.