Timing Is Everything

STUDENT'S VERSION

This lesson printed from:
http://www.econedlink.org/lessons/index.php?lid=865&type=student

INTRODUCTION

Income after taxes is used for two purposes: spending and saving. The benefit of consuming things today versus the benefit of consuming some things later through saving depends upon your understanding of opportunity cost. The opportunity cost of a decision is the most highly valued forgone alternative. For example, if you choose to buy new athletic shoes, you give up the opportunity to buy something else with your income today or you give up the opportunity to save your income for use in the future.

Most young adults do not save because they perceive that the opportunity cost is too great. However, when they begin to understand the power of compound interest over time, they may decide that the benefits of saving are, in fact, greater than the benefits of spending the money today.

Financial success is rarely achieved unless individuals choose to postpone some current spending so that they can save some income. Many young people think they don't have enough income to save and, as a result, they don't get off to an early start on a regular saving program. Young adults who choose to start saving early and regularly to take advantage of the magic of compound interest can build their personal saving into a comfortable nest egg.

To learn more about these points, please complete the following exercises.

(Please note: These activities are best accessed using Netscape or Internet Explorer for the PC platform or Netscape for MacIntosh. They will not perform using Internet Explorer for MacIntosh.)

TASK

In the first part of the lesson you will examine the incentives and opportunity costs of spending and saving. The remainder of the lesson is an interactive web site. You will work through problems that demonstrate the power of compound interest.

Activity 1

First Name
Last Name
Age

Select the number of hours you wish to work during a month. You will earn $6.00 an hour.
At $6.00 per hour, your monthly income will be

In this lesson, you have learned about saving and spending. Now that you know your monthly income, you must determine how much of your income you wish to save each month.
Select the percentage you wish to save each month.
Your total savings each month will be

At this rate, use the calculator below to figure how much you will have saved after:

calculator
A check mark will appear when your answer is correct. check-mark graphic
1 year
5 years
10 years

 

Activity 2

With the income you receive and the percentage you are saving, you have determined that after 10 years you will have saved a total of So, , do you have a plan for future savings? Consider the following two options.

Plan 1
You decided in Activity 1 to save of your monthly income. You continue to save this amount for 10 years in an account that pays interest at a rate of 7% per year. The interest rate is interest expressed as a percentage.

After 10 years, at the age of , you no longer contribute money to your savings and leave it in the account until you reach the age of 65.

Plan 2
You decided in Activity 1 to save of your monthly income. You periodically make withdrawals from your savings. At the end of 10 years, you have no savings. You do not save any money until you reach the age of 35. When you become 35 years old, you decide to begin saving again. You decide to save the same amount every year that you saved when you were You continue to save this amount each year until you reach 65.

Which plan will provide you with more value at retirement?
  

 
Deposit
Interest
Total Savings
Plan 1
$
$
$
Plan 2
$
$
$

Use the information from the chart to answer the following:

  1. How much will you have contributed to your retirement in
    Plan 1
    Plan 2
  2. What is the value at retirement and your net earnings at age 65 in
    Plan 1
    Plan 2
  3. In plan 2 you contributed much more to your retirement than in plan 1. Yet you never caught up with the value of your net earnings in plan 1 at retirement.

 

Activity 3

You learned in Activity 2 the power of compound interest. Interest is the price paid for the use of someone else's savings. Compound interest is interest earned on saving that includes previously earned interest.

How does compound interest work?

Suzy Saver and Tommy Savalot each have accumulated $2,000. Suzy and Tommy are putting their $2,000 in an account that pays 5% interest per year. Suzy leaves her interest in the account where it will compound at the 5% rate. Tommy withdraws his interest each year and uses it to buy himself something special.

After one year what will the total savings be?

calculator
For Suzy
For Tommy

In year 2, Suzy and Tommy each deposit another $2,000 into their accounts. At the end of year 2, how much interest do they receive?

calculator
For Suzy
For Tommy
 

Suzy keeps her interest in her account. Remember, Tommy does not leave any of the interest in his account. At the end of two years, what are the total savings?

calculator
For Suzy
For Tommy

Now consider how much Suzy and Tommy will have in their accounts after 20 years. If Suzy and Tommy continue to save for 20 years, what will their total savings be?

calculator
For Suzy
For Tommy

In both Suzy's and Tommy's saving program, the rate of interest was the same: 5%. However, Suzy's total savings at the end of 20 years was $69,438.42 and Tommy's was $40,000. Suzy earned more money because her interest was compounded.

Challenge Question
Now assume that Tommy deposited his money in an account that paid interest at a rate of 3%. Also assume that he left the money in that account to accumulate interest for 20 years just like Suzy.

Calculate the total amount of savings Tommy would earn if he allowed interest to compound at the 3% rate over 20 years.

calculator
   

In this case, even though Tommy earned compounded interest on his money, he would still have less in total savings than Suzy had after 20 years. That is because Tommy's money was earning interest at a rate of 3% as opposed to Suzy's 5%.

Saving For College

For the past 10 years the average cost of college tuition and fees has risen nationally at the rate of about 5% per year, consistently outpacing the rate of overall inflation. Given these numbers, the average cost of a college education in 18 years may be as much as $85,000 for a four-year public institution and more than $200,000 for a four-year private institution.

The cost figures given above demonstrate just how important it is to save, not only for college but also for any other goals that you may have. Using the college example, however, you can see that in order to build up the savings that may be required, you must begin a savings program as early as possible. This entire lesson demonstrates that "Timing is Everything." The magic of compound interest can make a big difference in helping you to attain your goals.

Many states have begun to offer tax-deferred college investment plans. They are easy to set up and offer many advantages. Tax-deferment until the time of distribution plus the power of compound interest will cause savings to grow much faster than they would in a taxable savings plan.

>By investing even a small amount on a regular basis, you can accumulate a significant amount for your college fund.

Monthly Investment 5 Years 10 Years 15 Years 20 Years
$50.00 $3,467 $9,006 $16,880 $28,450
$100.00 $7,294 $18,012 $33,761 $56,900
$300.00 $21,883 $54,037 $101,282 $170,700

The example above illustrates the future, value of savings based on three different savings plans for four time periods, assuming an annual investment return of 8%.

CONCLUSION

Particularly in the example about college savings plans, this lesson demonstrates how quickly your money can grow. As we know, income after taxes can be used for two purpose: spending and saving. When you consider how you will spend your money in the future, please keep in mind the opportunity cost associated with your spending choices and the overall impact of those choices on your future.

Many young people don't think they have enough income to save. As a result, they postpone a regular saving program. How can this decision be costly in the long run?

Remember:

  • The amount saved is not as important as saving on a regular basis!
  • The more time you have to save, the more savings you will have at the end of the time period.
  • The more income you choose to save, the more savings you will have at the end of the time period.
  • The higher the interest rate the more savings you will have at the end of the time period.

ASSESSMENT ACTIVITY

Print the lesson directly from your browser when you have completed the lesson. Turn it in for grading.

EXTENSION ACTIVITY

Students can visit The Mint website to learn more about the importance of earning and saving.