WHEN YOU ESTIMATE how much a dollar today will be worth in the future, or how much a series of regular deposits will be worth in the future, you’re calculating a future value. But sometimes, you’ll want to reverse engineer this calculation.
Suppose you figure you’ll need $40,000 in four years to make a house down payment. To have that sum, how much would you need to set aside today—or how much would you need to save every month? This is a present value calculation. To do the calculation, you need to estimate your likely rate of return. Let’s say you can earn 3% a year.
To have $40,000 in four years, you would need to invest $35,539 today, assuming a 3% annual return. Alternatively, to have $40,000 in four years, you would need to save $783 every month, again assuming a 3% annual return. You can do these calculations with a financial calculator or by playing around with the Present Value Goal Calculator at Dinkytown.net.
On occasion, you might hear experts refer to the “time value of money.” The notion: $1 today is worth more than $1 a year from now, because you could earn interest or investment returns during the intervening 12 months. In the above example, you can see that, to have $40,000 in four years, you need less than $40,000 today—illustrating the time value of money.
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