What is Time Value of Money?
You have probably heard the term “time value of money.” But do you know what it is?
Simply put, time value of money (TVM) is a concept that describes how money is valued at different times or over time.
For example, if you put $100 under your mattress today and then took it out 10 years later, you still have $100, but the TVM has likely decreased as it would not buy you as much in 10 years as it would have bought you today. In essence, the money that was worth $100 of buying power today, may only be worth $92 of buying power 10 years from now. That is the time value of money.
The Importance of Time Value of Money in Real Estate Investing
It is important for any real estate investor to understand the concept of the time value of money because it plays a major part in determining what future cash flow from a real estate investment will be worth in today’s dollars. When you take a mortgage to buy an investment property, the time value of money equation is the present value of all of the payments you will need to make over the term of your mortgage.
Understanding the time value of money is important to real estate investors as a financial planning tool to determine whether you are better off using your cash now for a rehab, or borrowing money and conserving your cash for a future project or another purpose.
It can also help formulate a savings plan for how much would you need to invest in today’s dollars to have a specific higher amount in the future.
The Time Value of Money Formula
Time Value of Money Example
Madeline is a real estate investor.
Madeline has $1,000 that she can invest at 5% for 10 years.
The time value of money equation would look like this:
FV = 1000(1 + .05)10
Using this equation, FV = 1,628.89.
What we have learned is that the $1,000 that Madeline invests today under the terms set above would be worth $1,628.89.
As a real estate investor, Madeline has to decide if she wants to hold onto her $1,000 today and borrow the funds for her rehab project by figuring out the costs she will have to pay for the loan, versus the amount of money she will have at the end of the time period.
By using the time value of money equation, she knows that by holding onto the money for 10 years at 5% interest she will have an additional $628.89 at the end of the time period (if successfully invested at a 5% return).
In most cases, this gain will be subject to income tax. If she puts her money into the project rather than holding on to it, she will likely pay more in interest than she could have earned if she had the funds invested (as that is the underlying principal of capital markets).
But there is more to be taken into account…
Inflation and Real Estate Values
Money invested in real estate can frequently be a hedge against inflation. Even in times of low inflation, the cost of goods increases over time. Real estate values tend to follow in the same way. The piece of real estate Madeline invested in may appreciate more than the $628.89 she is earning on her invested money.
Furthermore, because Madeline is rehabbing as a business endeavor, she can deduct the costs of the loan from any profits she makes from her income tax, which has a huge effect on increasing her actual gain at the end of the project.
For example, let’s assume Madeline paid 6% interest only on the $1,000 she borrowed for 10 years. Let’s also assume that she is in a 24% federal tax bracket and 3% state tax bracket. The $628.89 in interest she spent has now saved her $216 in taxes.
The difference between the increase of value of the $1,000 if saved and the amount paid for investing that money is now $384. While there is still a difference in gain/cost for borrower funds, she has retained the use of the $1,000 for other investments and opportunities to realize the $628.89 gain, reducing the cost of borrowing funds even more.
Time value of money is a helpful tool in evaluating whether you borrow funds for your rehab project, use your own funds, or do both. It is vital to understand the mechanics of investment and debt in order to determine the most effective tools for your rehab business.
Now that you’ve mastered the Time Value of Money Formula, check out of our Real Estate Formulas to help you to predict when a real estate investment will be a success!