Concept of Time Value of Money
‘Time Value of Money’ is the fact that the money received today is worth more than the same amount of money received at a future date. To put it in a different manner, the value of a rupee to be received in future is less than the value of a rupee on hand today. This may appear quite simple, but it emphasizes the concept of interest and can be used to compare investments, such as loan, bond, mortgages, leases and savings.
Ex: If a person has an option either to receive Rs 1000 today or receive the same amount of money after one year, in all probability he would opt to have the money today. The logic behind such preference is that the money receivable in future is of less value as compared to the same amount of money received today. Such preference for the present money as against the future money is termed as the “Time Preference for Money”.
In simpler terms, the value of a certain amount of money today is more valuable than its value tomorrow. The difference between the value of money at ‘present’ and its value ‘at a future date’ is referred to as the “Time Value of Money”.
Simple Interest and Compound Interest
Simple Interest: It is the interest paid or computed only on the original amount of a loan or on the amount of an account and not on the interest it has already earned.
Compound Interest: It is the interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. It may be considered as ” interest on interest”, and it makes a deposit or loan grow at a faster rate than that of a ‘Simple Interest’, in Which interest is calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding. The higher the number of compounding period, the greater the compound interest.
Compounding of interest involves reinvestment of each interest payment with a view to earning further interest in future. Compound interest can be yearly, semi-annually, quarterly or even continuously.