Time value of money

published 13 May 2018

Even if inflation and interest rates are zero, money has a time value. If you are owed £10, you would rather it was paid back now than in, say, one year's time. That's because the borrower is less likely to pay you back if you wait.

Now throw in interest rates. Lend someone £100 now with interest rates at 5% and if they return £100 in one year you've actually lost out. That's because you could have earned £5 of interest in the meantime. So they should be paying you £105 and that assumes you were happy to accept zero default risk when you made the loan. Equally, if you lend the £100 over two years you should expect £100 x 1.05 x 1.05 back, or £110.25.

In reverse, the "present time value" of £110.25 due in two years time but received today instead is £100 (if interest rates are a constant 5%).