What is "Future Value?"
When you place an amount of money in an account or an investment that earns compounding interest (earns interest on interest paid), future value is the amount to which the original deposit or investment will grow to based on the compounding rate and interval (daily compounding, monthly compounding, etc.), and on the number of months or years.
Because Future Value (FV) is the result of interest being earned on previously earned interest, future value is also referred to as compounding. Therefore, a compounding interest calculator is virtually the same thing as a future value of money calculator.
What are Future Value Calculations Useful For?
Suppose you have a lump sum of money and you have several choices of where to invest or deposit the lump sum. Further suppose that these choices come with different interest rates and compounding intervals. Future value calculations allow you to compare the growth of each option against the growth of all other options.
A second, and more important use of future value calculations, is for determining the financial opportunity costs of spending a lump sum of money on a depreciating asset (value diminishes with time and use) or on an expendable (value is expended upon use or purchase) instead of investing it.
Example of Opportunity Cost Using Future Value
Suppose you are considering spending $5,000 on a vacation. In order to make an informed decision, you need to know and give equal weight to the financial opportunity costs that will come with an expenditure of the $5,000 for an expendable.
If you have at least 30 years until you can retire, and could earn 6%, compounded monthly on the lump sum if you invested it, future value calculations will tell you that the financial opportunity cost of going on vacation will be $25,112.88 (future value of $30,112.88 less the original $5,000). That is how much interest earnings you will be giving up by going on vacation.
Going one step further, you could also determine how much time off from work you could take after 30 years of earning 6% interest. If you take home $15 per hour and work 40-hours per week, this means you could take roughly 50-weeks off from work 30 years from now ($30,112.88 ÷ $600 per week = 50.19 weeks).
Sure, it's true that the above opportunity cost calculation doesn't account for inflation (erosion of buying power) and income taxes. But the question you need to ask yourself is, in 30 years which would I rather have, faded memories of 1-week vacation, or $30,112.88 in savings?
If you still choose to spend the lump sum on the vacation, then at least you made an informed decision.
