Unit 5 · Topic 5.3 · about 35 minutes
Saving and Investing for Education, Housing, and Retirement Goals
Not assessed on the AP Exam. Unit 5 is part of the course, but nothing in it is on the exam.
Explain how planning gets a household to its education, housing, retirement and giving goals, and recommend where to keep the money for each goal based on its time horizon and the household's risk tolerance.
Predict first
Ava invests $2,000 at the start of each year from age 22 through 31, then stops. Ben waits, then invests $2,000 at the start of each year from age 32 through 61. Ava puts in $20,000 in all and Ben puts in $60,000. Both earn 7% a year. At 62, who has more?
Goals that are years away
Long-term financial goals often include paying for postsecondary education (for yourself or a child), buying a home and saving for retirement. None of them can be paid for out of one paycheck, so each needs a plan: how much money it takes, when it will be needed, and how much can be set aside each pay period.
Families with combined finances, such as a two-income married couple, can head off a lot of financial strife by talking through these goals and agreeing on them.
Saving on willpower alone is hard, and some financial technology takes willpower out of it. An automated savings plan moves a set amount into savings every payday. Payroll deduction for a retirement account takes the money out before the paycheck even arrives. Both get past the barriers that make saving difficult.
| Goal | Decisions it involves | How it is usually paid for |
|---|---|---|
| Postsecondary education | Where to go to school and what to study, based on career goals and available funding | A combination of savings, student loans, scholarships, grants and work-study programs |
| A home | Where to live, and whether to rent or buy, based on preferences and available funding | Savings for a down payment, plus a mortgage loan the buyer has to qualify for |
| Retirement | When to retire and where to live, based on preferences, health and well-being, and available funding | Social Security, employer-sponsored retirement plans, personal investments and continued earnings |
Paying for each goal
School. Scholarships and grants do not have to be paid back; student loans do, with interest. Federal student loans may have lower interest rates and more favorable repayment terms than private student loans, and they may be government subsidized, so compare the two before you borrow.
A home. The down payment comes from savings, and the rest is borrowed through a mortgage loan. The monthly payment depends on the size of the loan, the repayment period and the interest rate. A fixed rate stays the same for the life of the loan. An adjustable rate can change over time, and the payment changes with it.
| Loan | Interest rate | Repayment period | Monthly payment |
|---|---|---|---|
| $250,000 | 6% | 30 years | $1,498.88 |
| $250,000 | 6% | 15 years | $2,109.64 |
| $250,000 | 7% | 30 years | $1,663.26 |
| $200,000 | 6% | 30 years | $1,199.10 |
A smaller loan lowers the payment: borrowing $200,000 instead of $250,000 cuts it by $299.78 a month. That is why the size of the down payment, which sets the size of the loan, is worth planning for years ahead. A rate of 7% instead of 6% raises the payment by $164.38. The shorter repayment period raises it the most, but it cuts the total interest paid over the life of the loan from about $289,600 to about $129,700.
Retirement. In the U.S., retirement income typically comes from a combination of Social Security, employer-sponsored retirement plans, personal investments and continued earnings, such as part-time work.
Giving. Charitable giving is a goal too. Which organizations to support, and whether to make a one-time gift, give recurring donations or leave a legacy contribution, depends on your goals and on how well each nonprofit's mission and impact match them. Giving can also bring financial benefits, such as a tax deduction.
Where to keep the money
Money saved toward long-term goals can be held in different financial assets: savings vehicles such as savings accounts and CDs (3.1 Saving for Future Purchases), individual stocks and bonds, and mutual funds, which pool money from many investors and invest it in stocks, bonds or both.
These assets differ in their potential risk of losses and in their expected returns. Some are low risk because they are government insured, like a savings account at a federally insured bank, or because they provide guaranteed income, like a U.S. Treasury bond, whose interest the federal government backs. Those typically have lower expected returns. A bond from a business is riskier, because the business only promises its interest and could fail to pay it. Individual stocks are riskier still, because the value of a stock depends on the success of one business. Investors accept that risk because stocks are expected to provide higher returns.
Which asset fits a goal depends on your risk tolerance and on your time horizon, how long until you need the money. When you start matters too. Because of compounding, people who begin saving and investing young and hold their assets a long time realize greater returns than people who wait. That is what happened to Ava.
| Financial asset | Risk of losses | Expected return | Usually fits |
|---|---|---|---|
| Savings accounts and CDs | Low: federally insured | Lower | Low risk tolerance or a short time horizon |
| Individual stocks | Higher: value depends on one business | Higher | Higher risk tolerance and a long time horizon |
| Mutual funds | Depends on whether the fund holds stocks, bonds or both | Depends on the mix | Investors who want many stocks or bonds at once; stock funds suit higher risk tolerance |
What shrinks a return
Fees. Buying, selling and holding financial assets can cost money: transaction fees, management fees and fees for professional advice. Every fee decreases your return on investment. Most people buy stocks and bonds through a broker, so many investors choose discount brokerage firms, which charge lower fees and provide less investment advice than full-service firms. A small yearly fee adds up over decades. At 7% a year, $10,000 grows to about $76,100 in 30 years. At 6%, the same return after a 1% yearly fee, it grows to only about $57,400.
Taxes. Taxes on investment returns, such as interest, dividends and capital gains (5.1 Taxes, Net Income, and Budgeting), decrease the return too. Before choosing an asset, investors consider whether its returns will be taxed and, if so, at what rate.
Inflation. Inflation reduces the purchasing power of money over time, so it decreases the real (inflation-adjusted) return on an investment. The return before any adjustment is the nominal return. For a quick estimate of the inflation-adjusted return, subtract the inflation rate: a CD that pays 4% in a year when prices rise 3% leaves you only about 1% ahead in what your money can buy. Investors look at both numbers.
Two biases that cost investors money
Investors are human, and common behavioral biases can lead them into decisions that hurt their return on investment. Overconfidence can cause investors to take unnecessary risks, such as putting all their savings into one stock they feel sure about. Loss aversion, the tendency to feel a loss more sharply than a gain of the same size, can cause investors to sell financial assets prematurely at a loss: prices drop, they panic and sell, and they are out of the market for any recovery that follows.
Building the plan
A saving and investment plan decides how to allocate money among different financial assets. The usual considerations are how much money the goal requires, how much you can save each pay period, the time horizon (how long until the money is needed), your risk tolerance, and the expected rate of return on each type of asset.
With a longer time horizon, you are more likely to invest in assets with higher risk and higher expected returns, because you can wait for them to regain value after a downturn. With a shorter time horizon, safer assets make more sense, because you may need to sell during a downturn, which could mean losses or a lower return than you expected.
Risk tolerance shapes the choice too. People with low risk tolerance typically use safer assets, such as federally insured savings accounts and CDs, and receive a lower rate of return. People with higher risk tolerance are more likely to invest in stocks and mutual funds.
Financial advisors often suggest a diversification strategy: allocating money to a variety of financial assets with different levels of risk and expected return. Diversification lets you seek higher long-term returns without taking on excessive risk, because no single asset's bad year can sink the whole plan.
Worked exampleA plan for the Reyes household
Carmen and Luis Reyes have agreed on three goals together. They want $21,600 for a home down payment in two years. Their daughter, now 4, starts college in 14 years. They plan to retire in about 30 years. After their monthly expenses they can save $1,300 a month, and Carmen's employer offers a retirement plan through payroll deduction. Recommend where the money for each goal should go.
Fund the short-horizon goal first, and safely. 21,600 divided by 24 months is $900 a month. That money belongs in a federally insured savings account or in CDs that mature before they buy. If stock prices fell the month before they bought the house, they could not wait for a recovery.
Send the long-horizon money where it can grow. That leaves 1,300 minus 900 = $400 a month for college and retirement. With 14 and 30 years to go, they can wait out a downturn, so this money can go mostly into stock mutual funds, with some bond funds, for higher expected returns.
Automate it. The retirement share goes through payroll deduction into Carmen's employer-sponsored plan, so it is saved before the paycheck arrives. An automated savings plan can move the house and college money every payday.
Diversify and keep score. Each mutual fund spreads its money across many stocks or bonds, and mixing stock funds with bond funds adds assets with different levels of risk. Once a year, they can compare their stock funds with a benchmark: a stock index, which tracks a large group of stocks.
Put $900 a month into insured savings for the house and the remaining $400 into diversified mutual funds for college and retirement, all of it saved automatically. As the college date gets close, that goal's time horizon shrinks too, and its money should move toward safer assets.
Advice and a yardstick
You can also seek advice from financial professionals to help evaluate your saving and investment options. When selecting an advisor, people typically consider licensing, certifications, education, experience and cost, since advice fees come out of your return like any other fee.
Once the money is invested, you need a way to tell whether it is doing well. Investors often compare the performance of their assets against a benchmark, such as a stock index or a bond index, which tracks a large group of stocks or bonds. If your stock fund gained 6% in a year when a broad stock index gained 9%, your fund lagged its benchmark, and it is fair to ask why.
Check your understanding
Jada needs to borrow $5,000 for her first year of college. She has offers for a federal student loan and a private student loan. What advantage may the federal loan have?
Two mutual funds hold the same stocks and earn the same return before costs. Fund P charges a management fee of 0.2% a year and Fund Q charges 1.2%. You plan to invest for 25 years. What should you expect?
A CD earned a nominal return of 4.5% last year, while prices rose by 3.2%. Estimate the CD's inflation-adjusted return, as a percent rounded to one decimal place.
Leo is 30 and saves for retirement in stock mutual funds. When stock prices fall 20% over two months, he sells everything so he cannot lose any more. Which best describes his decision?
The Kims will need $30,000 for a home down payment in 18 months, and they cannot afford to come up short. Where should they keep that money?
Worked exampleOne deposit, compounded two ways
Nia deposits $2,000 in a savings account that pays 5% annual interest and makes no other deposits or withdrawals. What is her balance after 3 years if the interest is compounded once a year? What is it if the interest is compounded monthly? Round to the nearest cent.
Compounded once a year. Each year the bank adds 5% of the balance, which multiplies the balance by 1.05. After one year: 2,000 times 1.05 = $2,100. After two years: 2,100 times 1.05 = $2,205. After three years: 2,205 times 1.05 = $2,315.25.
Interest earns interest. At 5% of the original $2,000 alone, Nia would earn $100 a year, or $300 in three years. Compounding paid her $315.25. The extra $15.25 is interest earned on earlier interest.
One step instead of three. Multiplying by 1.05 three times is the same as multiplying by 1.05 to the third power, written 1.05^3. With a calculator's power key (often marked ^), 2,000 times 1.05^3 = $2,315.25. For 20 years, the power would be 20.
Compounded monthly. Each month the bank adds one twelfth of the yearly rate: 0.05 divided by 12 = 0.0041666..., a decimal that never ends. So each month the balance is multiplied by 1.0041666..., and in 3 years that happens 36 times: 2,000 times 1.0041666... to the 36th power = $2,322.94. Let the calculator keep every digit by entering the rate as 0.05 divided by 12. Rounding it to 0.0042 first gives $2,325.72, which is $2.78 too high.
Compounded once a year, Nia's $2,000 grows to $2,315.25 in 3 years. Compounded monthly, it grows to $2,322.94, which is $7.69 more, because the interest is added every month, so it starts earning interest sooner.
Course alignment, for teachers
AP Business with Personal Finance topic 5.3, Unit 5: Personal Goals, Budgeting, and Investing.
- Skill 1.A: Describe business and personal finance concepts, principles, and strategies.
- Skill 1.B: Interpret quantitative and qualitative business and personal financial data, performing calculations as appropriate.
- Skill 1.C: Using business and personal finance concepts and principles, explain how and why businesses and individuals pursue specific goals, strategies, and actions.
- Skill 3.A: Describe internal, market, and external factors that affect a business or individual, and explain how and why they create opportunities and/or problems.
- Skill 4.A: Present business and personal financial data (e.g., data visualizations and financial statements) in accurate, precise, and accessible formats targeted for a specific audience and purpose.
- Skill 4.B: Create authentic business communications (e.g., surveys, business canvases, and pitches) that are targeted for a specific audience and purpose.