Understanding the Time Value of Money (TVM)

An Annuity is any sequence of equally spaced payments made over a certain period of time with a definite end date. For example, a car loan is typically paid in monthly installments of the same amount for a period of five years. This is an annuity payment on the car. This should not be confused with perpetuity, which is the same type of payment but made infinitely, or forever. (Brealey, Myers, Marcus, 2003)

An annuity can affect the outcome of an investment based on the terms of the payments. The longer it takes to pay off an investment, the more interest is paid in, which can mean a loss to the investor. For example, if a car loan is taken out for 60 months, or five years, the buyer may have a larger monthly payment, but the principal will be paid off faster than if paid over a period of 72 months or six years.

Compound interest is the concept of interest upon interest. It is making interest on the principal plus the interest rate instead of just the principal. Interest rates increase the amount of the investment and the return to the investor. Compound interest means more money to the investor, because they are earning on the interest as well as the principal. As the rate of interest increases the rate of return, the investor makes more money.

Present value is the dollar amount needed to reach a certain financial goal. The more there is to start with, the higher the Future Value, which is that goal, is likely to be. For example, if a college fund is set up for a child upon his or her birth, with the intention of the fund having $100,000 in it by the child's eighteenth birthday, how much will the fund need to start with in order to achieve this goal? That's present value. Present value's impact on TVM is that the amount of the original investment can be increased due to interest that it will earn over the years.