Real Life Application of Time Value of Money

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Real Life Application of Time Value of Money

Time value of money (TVM) is a concept that is based on the principle that the value of a dollar is more valuable if it is received today than if it is received in the future. This is because money has the capacity to earn interest, for instance, by saving it in a bank. A fundamental concept that enhances the applicability of this concept is that the present value of a series or a given amount of money of equal receipts or payments anticipated in the future can be calculated. Conversely, the future value of a series or a given sum of money anticipated to be received or paid in a future date can be calculated. In life, the concept of time value of money has become applicable in various fields. In this essay, various real life applications of time value of money will be discussed.

Adjustable rate Mortgage

This is a mortgage loan that has the interest rate on the note, which is adjusted within given intervals using an index. The index reflects the cost to the financier of borrowing on the money markets. This type of loan is at times issued at the standard variable of a lender or even the base rate. Sometimes, there might be a direct genuine link to the index, and in case the lender fails to come up with a well-defined link to the underlying market, the index rate is to be changed according to lender’s discretion. Time value of money helps in deciding the value of money in the future. TVM helps mortgage firms in coming up with the right rates of making sure the firm recovers the issued loans together with the interest rate charged on the loan (Weygandt & Kieso et al., 2003).

An example of an ARM containing the four basic features

This type of ARM has no limit when it comes to the increase in the amount to be paid.

The monthly payments exclude (taxes, insurance, and mortgage insurance in case they exist). Calculation for the first year

In this calculation it is assumed that at the end of the first year the index is 11%. This means that the index rate of 11% will be added to the margin of 2%, to achieve the new interest rate of 13%. The calculations at the end of the first year will be as below:

This implies that in the first year, the individual only paid $ 362.88 on the loan principal. The new balance will be realized on the balance of $ 99,637.12, with a period of 29 years, because the loan is only one year old. The new monthly period will be:

This indicates that the monthly period is increasing by $ 76.80, which is a 1 % increase in the index within a period of one year.

Certificate of Deposits

A certificate of deposit (CD) is defined as a time deposit in a bank. It is issued by commercial banks, but it can be purchased through brokerage firms. It is known to be carrying with it a maturity date, which varies from three months to five years. In addition, it contains a well-defined interest rate, and it are issued in several denominations. This makes the certificate of deposit be compared to bonds. CDs are known to be a safer form of investment, which gives higher yields in terms of interest rates when compared to the normal savings deposit. Time value of money helps investors using CDs in deciding whether to invest in a short-term or long-term project (Freyermuth, 2001).

A good example of how CD functions is in the case where an individual purchases a one year, $ 2000 CD, which pays 5% semi-annually. This means that in six months the individual will receive an interest amount of $ 25 ($ 2000 * 25% * 5 years). Consequently, the $25 payment will then start earning interest of its own. Time value of money application helps realize the rate of return before the maturity time, and this is a great encouraging to investors, who are willing to venture in CD’s.

Loan Amortization

Loan amortization is the process of paying back a loan by making gradual payments periodically. The gradual payments comprise of the interest and the principle amount. This process uses an amortization schedule, which is a list of balances, payments, and interest charges from the inception of a loan until it is paid off. Loan amortization involves calculation of payment per period, determination of interest in each period, calculation of principal payment in each period, and determination of the loan balance in each period. In determining the periodic payments, the time value of money comes in. Loan amortization establishes the amount payable and the time of payment, hence making the management of loans an easy task (Weygandt, Kieso & Kimmel, 2003).

References

Freyermuth, R. W. (2001). Anatomy of a mortgage. Chicago, Ill.: Section of Real Property, Probate and Trust Law, American Bar Association.

Weygandt, J. J., Kieso, D. E. & Kimmel, P. D. (2003). Financial accounting. New York, NY: Wiley.