What is the principle of time value of money?

The principle of time value of money centers on the notion that a specific amount of money today holds greater value than that same amount in the future due to its potential earning capacity. This concept is rooted in several financial principles, including the potential for investments to generate returns over time, the impact of interest rates, and the fact that money can be invested today to earn additional income or grow in value.

When you receive money now, you have the opportunity to invest it and earn a return, whether that's through interest, dividends, or capital gains. For example, if you have $100 today and invest it at an interest rate of 5%, in one year, it will grow to $105. Conversely, if you only receive that $100 a year from now, you miss out on this earning potential.

This principle also highlights the effects of inflation, as money tends to lose purchasing power over time, further emphasizing the importance of having and utilizing funds sooner rather than later. Therefore, the rationale behind the time value of money is foundational for making informed financial decisions about saving, investing, and understanding the implications of interest rates in the context of future financial planning.