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.)
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.
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?
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|
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%.
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?
- 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.
Print the lesson directly from your browser when you have completed the lesson. Turn it in for grading.
Students can visit The Mint website to learn more about the importance of earning and saving.