Say you want to start a college fund for your child. You know that, in 20 years, you’ll need $100,000. How much do you need to put away today for it to accrue enough interest in the given time frame?
On the other hand, say you’re saving for retirement. If you put away $1,000 today, how much will you have in 40 years when you retire?
To answer these questions, we’ll rely on the future value of money, an aspect of the time value of money that allows you to know how much an investment of a certain amount will be worth in the future at a given rate of return.
In this article, we’ll examine this useful tool, the formula used to calculate it, how it can be used, and its pros and cons.
What is Future Value?
The future value of money derives from the concept of the time value of money—the idea that a dollar today is worth more than a dollar in the future. This is because that money can be invested and earn interest or some other form of return.
With future value calculations, you are taking that dollar today and determining how much it will be worth at some date in the future. In other words, future value is the value of an investment at a future date based on an assumed rate of growth.
This is an important tool in sound financial planning as it allows potential investors to know how much a given investment today will be worth when they need it in the future.
Likewise, if you are looking to have a certain amount at a certain date (like with your kid’s college fund), it can tell you how much must be invested today to meet your goal.
Knowing future value calculations allows an investor to anticipate their future needs and make sound investment decisions based on these needs, such as how much they’ll need to pay for college or their retirement plans.
However, external factors, such as inflation, an increase in the price of college, or increased costs of living, can erode the spending power of these investments.
The future value can be calculated using either simple or compound interest. Using simple interest, we’ll use the formula:
FV = I x (1+(R x T))
FV = Future Value
I = Investment
R = Interest rate
T = Number of years
So, assuming a 10% rate of interest, let’s return to the above retirement example. If you put away $1,000 today, how much will you have in 40 years? Simply plug in the numbers:
FV = $1,000 x (1+(.1 x 40)) = $1,000 x (1+(4)) = $1,000 x 5 = $5,000
With a little bit of algebra, we can also use it to find how much must be put away today to hit your target for the college fund, which, if you recall, was to have $100,000 in 20 years.
Simply start with plugging in the FV, leaving the PV as the variable to be solved for as such:
$100,000 = PV x (1+(.1 x 20)) so PV = $100,000/(1+(.1 x 20)) = $100,000/3 = $33,333.33
In other words, you could find that you’d need to save $33,333.33 today to have the money you’ll need to pay for college in twenty years.
You can also do these calculations assuming a compounded interest. In this scenario, the formula is:
FV = I x (1+R)T x n
FV = Future Value
I = Investment amount
R = Interest rate
T = Number of years
n = number of compounding periods per year
Note that, with annual compounded interest, n = 1, so the formula can be simplified to:
FV = I x (1+R)T
To show this formula in action and demonstrate the power of compounded interest, let’s return to the retirement example and invest $1,000 at 10% interest, only this time the interest will be compounded annually.
FV = $1,000 x (1+.1)40 = $1,000 x (1.1)40 = $1,000 x 45.259 = $45,259.26
As you can see, simply by using compounded interest over simple interest, you’ve earned nine times the return on your investment.
If you had to use a calculator for this last one, don’t worry—so did I. In fact, you can find many online calculators designed specifically for calculating the future value of investments, including this one.
Determining the Rate of Growth
Now that you understand the basic principle of future value, let’s look at a complication; namely, determining the rate of growth.
As we said in the beginning, the future value is the value of an investment at some point in the future based on an assumed rate of growth. With something like a savings account with a guaranteed interest rate, determining future value is easy—you just perform the calculations like we did (or plug your numbers into an online calculator).
What about other investments, such as stocks? After all, one of the benefits or uses of future value calculations is to compare one form of investment to another.
However, stocks are more volatile—they may offer a better return in the long run, but they are unlikely to grow at a stable rate. This also requires making assumptions about the rate of growth, which can be inaccurate.
Likewise, riskier investments may appear to offer a better future value, but you must take into account their uncertainty—you may lose some or all of your money.
This is the reason they offer higher rates of growth. It’s to entice investors to choose them over more stable investment choices like savings accounts or bonds.
Future value calculations can help compare these investment choices and guide decisions, but you must still take into account the relative risk of each option and choose according to your needs and comfort with risk.
Advantages of Future Value
As we’ve discussed, future value calculations can help a great deal in financial planning. It can tell you how much you need to put away to save for your kid’s college or how much X amount invested today will give you when you retire.
By knowing what you have today and making assumptions about what you will need in the future, you can better understand your financial position. This helps you better plan for the future and makes you more prepared when it comes.
Future value calculations also make comparisons easier. In the real world, the choice is not simply whether to invest money or not; you have to choose between multiple investment options.
If choosing between option A, an investment that returns 10% annually, or option B, an investment that returns 5% in year 1, 15% in year 2, and 25% in year 3, which option should you choose? The only way to know is to perform future value calculations and compare the two amounts.
Finally, future value calculations are relatively easy to conduct. If you are assessing an investment with a guaranteed interest rate, then it’s simply a matter of using that interest rate and doing the math.
Even with more complicated investments, like stocks, the most difficult part is choosing an estimate for its rate of growth. Once that’s done, the calculation is simple.
Future value predictions can be very accurate when calculating investments with guaranteed interest but have several limitations with more complicated investments such as stocks or can be complicated if the calculations involve annuities or irregular cash flow.
They are still useful, mind you—however, these limitations should be kept in mind.
First, the formulae used above assume a constant rate of growth. This isn’t always realistic.
For example, stocks or any other investment pegged to the market may grow 4% one year and stagnate the next. The same goes for interest rates pegged or related to the Fed’s interest rate. They can be changed over time, especially for longer-term investments.
On a related note, the assumptions used in future value calculations may not come to fruition, and over-reliance on these calculations can lead to problems.
For example, if you plan to pay for your kid’s college by investing in the market with an assumption it will return 10% a year, then if the market only returns 5%, your kid might not be going to college.
Likewise, an erroneous assumption about the rate of growth can leave you high and dry during your golden years when that retirement savings yields less growth than you’d assumed.
They may also be insufficient for some comparisons.
For example, if you’re only looking at future value, then it would appear that an investment of $10,000 at a 10% rate of return would yield more than a $100 investment with a 700% rate of return. The future value of the former would be higher while disregarding that it required a hundred times greater investment.
Future value calculations are a crucial part of financial planning and should be used when planning for your future or choosing between different types of investments.
In this article, you’ve learned how to perform these simple calculations or find a calculator to do them for you. However, when making your own financial plans, you must account for uncertainty, the level of risk you are willing to accept, and the flexibility various instruments of investment afford in addition to your future value calculations.
The future value calculations we’ve gone over can help guide your decisions, but you should take these other, immeasurable factors into account as well.
We hope you enjoyed this article and that it will help you become more confident in planning your financial future. For more articles like this one, please subscribe. We hope to see you next time.