Tuesday, August 6, 2024
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ET Mutual Funds Explains: Want to know the future value of your financial goals? Use this formula

Mutual fund houses and advisors are actively promoting goal-based investing, urging investors to understand the importance of having financial goals and investing to achieve them. However, many investors struggle with calculating the future value of their goals. Instead of employing a precise calculation, they often choose arbitrary large figures like Rs 50 lakh or Rs 1 crore, assuming these amounts will suffice. What seems like a big number today may not hold its value in the future due to inflation, making precise calculations using inflation vital in planning for financial goals.

Many investors just pick a random number. Many investors pick up big numbers, usually Rs 50 lakh or Rs 1 crore which they think will suffice for their future. Inflation significantly reduces the purchasing power of money over time, so the amount that appears substantial now might not be enough in the coming years. The value of any investment does not remain the same always. It either decreases or increases due to interest rate, inflation/deflation which increases/ decreases the value of money. The impact of annual inflation erodes the purchasing power of money significantly with each passing year.

Investors need to account for the effects of inflation on their future financial goals. To do this, they first need to calculate how much a particular goal costs today. For instance, if a child’s higher education costs Rs 5 lakh today, the investor needs to determine how much time is left until they need to pay for the education. If the child is expected to go to college in 15 years, they need to calculate how much that same education will cost in 15 years, taking inflation into account. This is known as calculating the future value of the goal.

Calculating the future value of a goal involves a bit of math. For those who are numerically challenged, a simple formula can be used to make the process easier. The formula for Future Value (FV) is:

Future Value (FV) = Present Value (PV) x (1 + r/100)^n

In this formula:

FV = Future value of your goal

PV = Present value or current cost of your goal

r = Annual rate of inflation

n = Time left to reach your goal (in years)

Using this formula with the given example, if the annual education inflation rate is 10%, the cost of the education which is Rs 10 lakh today will be Rs 44,53,920 after 15 years. It is crucial to use a realistic inflation rate as different goals may have different inflation rates. For instance, education inflation may differ from medical inflation, and it is important to use the correct rate for each specific goal.

For those who prefer using excel, this calculation can also be done using the FV function in Excel’s ‘Insert Function’ feature under the Formulas tab. By entering the appropriate values, the future cost of a specific goal like child education after 15 years can be calculated effortlessly. For example, in the given case, the ‘Pmt‘ value is inserted as ‘0’ since there are no periodical payments or costs, and only a one-time expense is being calculated.

Understanding and calculating the future value of financial goals is essential in effective financial planning. Instead of relying on random large figures, employing accurate calculations that account for inflation can ensure that the financial targets set today will indeed cover future needs. While it might seem complicated at first, using these straightforward formulas or excel functions can simplify the process, helping investors make informed decisions and achieve their financial goals confidently.

If you are an excel user, you may use the “insert function’ under the formula tab and choose FV function. Now start entering required values to calculate the cost of child education after 15 years. We have to insert PMT value as 0 as there are no periodical payments or costs. We are calculating the one time expense.