Our financial goals change as we move through life. In our 20s and 30s, we often build up debt to pay for some of the such as our college education, buying a home, or our children's college education.
While these goals may be investments in our future well being, any loans taken out to achieve them have to be repaid. By the time many of us manage to pay off this debt, we are in our 40s and 50s. Now we are faced with a new financial goal: Saving for our retirement.
With some basic skills in personal budgeting, you can identify opportunities early on to save for some of these future expenses. For one, it's important to set up a savings plan. Together with a personal budget, a savings plan adds discipline and helps you save for the future.
If you're mired in debt to where you can't think of saving, you shouldn't despair. A debt repayment plan can help you chip away at your debts. Debts repaid, you will eventually free up financial resources to save for the future.
Saving is the cornerstone of paying for future financial goals. A good savings plan means making regular contributions and not just a single, lump-sum investment. The following table shows future values of a savings account for a range of monthly contributions. An initial investment of $1,000 gets the account started. The account grows at 8% a year, compounded monthly:
|Future value based on these monthly contributions:|
As you can see, regular monthly contributions accelerate the growth in savings. For example, look at an investment horizon of 10 years. Your initial investment grows to $2,220. If you make monthly contributions of $100, the account grows to $20,636, a difference of $18,416. The total value of contributions is $100 for 120 months, or $12,000. These contributions add $6,416 ($18,416-$12,000) in interest to the account over the 10-year period.
Let's look at the same account after 30 years. Your initial investment grows to $10,936. If you make monthly contributions of $100, the account grows to $160,965, a difference of $150,029. The total value of contributions is $100 times 360 months, or $36,000. The extra contributions add $114,029 ($150,029-$36,000) in interest to the account. If you divide $114,029 by three, you get $38,010. Interpretation: for a 30-year period, contributions of $100 a month add $38,010 in interest to the account, on average, for each of the three 10-year periods. This is more than six times the amount of interest earned in the first example.
Clearly, compounding has tremendous benefit over time. The following is a list of the major variables that affect growth of a savings account:
Amount of contributions. Your initial investment is what gets your savings plan started. It can be as little as $10 or $25. Growth in an account benefits less from the initial investment than from regular contributions.
Frequency of contributions. The more frequently you contribute, the faster your savings grow with compounding. However, it's important that you don't over-contribute to the extent that you are having to borrow money at an interest rate that is higher than what you earn.
Investment horizon. Your investment horizon is the number of years you are able to save. The greater the number of years, the more your account will grow.
Use of tax-advantaged accounts. A tax-advantaged account allows your savings to compound faster than if you were to use a taxable account. Many tax-advantaged accounts are retirement accounts, which restrict your use of the money before you reach retirement age. However, the 2001 tax law expands the use of tax-advantaged accounts to save for your child's or dependent's college expenses.
Rate of return. The rate at which your account grows depends on the interest rate or rate of return. The risk-return trade-off is a basic rule of investing that requires you to accept more investment risk, as measured by the volatility in year-to-year returns, in exchange for a chance to earn a higher rate of return.
If you are a conservative investor, you are relatively risk-averse. As a result, a conservative investor should have lower expectations for investment returns than would an aggressive investor. Over time, stocks have averaged annual returns of about 12%. Since stocks have more risk than bonds or cash investments, a conservative investor should expect investment returns of less than 12%.
Saving for the future involves a few simple steps. You need to set up a personal budget and savings plan. You need to have the discipline to make regular contributions. The benefits of compounding, investing for the long term, and having realistic expectations of returns help you to plan your financial goals. When possible, using a tax-advantaged account helps your savings account grow faster.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.