Savings Plan LessonA savings plan is a critical part of your long term personal financial plan. It’s been said for many years that you should save at least 10% of your earnings and you should pay yourself first. It’s important that you understand the rule of 72 to help you identify how your money can grow. There are many types of saving vehicles you can use to help you execute your plan. There are Certificate of Deposits, Mutual Funds, Passbook accounts, Credit Unions, 401K, and Savings Bonds. It’s important that your savings plan gets you in the habit of saving at least 10% of your income for the future. As your income increases you will be able to add more. I started out saving what I could afford but every time I got a raise I put 10% of the raise into savings until I eventually got my savings up to over 16%. It’s also important that you pay yourself first because if not you will always find a reason to use the money for something else. That’s why in the beginning you may want to find a savings plan that is deducted from your pay check automatically. If your company has a 401K plan or a credit union both will usually deduct funds directly from your paycheck. The interest rate that you get on an investment is very important and is one of the factors you should consider when choosing a savings vehicle for your investment. The compounding of interest can have a phenomenal impact on the growth of your investment. To figure out how fast your money will grow at a specific interest rate start by learning how long it will take for your investment to double. The rule of thumb you can use to figure when your money will double is called the rule of 72. To figure out when your money will double you start with 72 and divide it by the interest rate that you are earning. For example if you invest $5000 and you are earning 10% interest the formula would be; 72/10=7.2 years. In 7.2 years you would have $10,000. Obviously the higher the interest rate the quicker your money will double. A certificate of deposit (CD) is one of the investment vehicles available to you. The CD is considered a pretty conservative investment because your original investment (principal) is guaranteed and you know up front how much interest you will earn for the committed time period. You have to commit to leave your money in the CD for a specified time period. If you decide to take funds out of the CD before the maturity date you will be required to pay a penalty and you will loose the interest you have gained. Many people don’t like this investment because of the typically low interest rate and commitment you have to make to receive the interest rate. The longer period you commit to the better the interest rate. One option available to you if you do commit to a long term CD and then find out that you need the money is to take out a secured loan secured by the money in the CD. The bank will feel comfortable giving you the loan because they have the money from the CD as collateral. The down side of this strategy is you will probably loose all of the interest that you gained from the CD but on the other hand you will have a lower interest loan. Sometimes people do this to help improve their credit. A mutual fund is another savings vehicle you can use. The benefit of mutual funds is there are all types of funds that you can invest in. You can choose a fund that meets your investment strategy, such as a stock fund that invest in only blue chip stocks (large well established companies with a proven track record), bond funds that only invest in a certain type of bond, a balanced fund that focus on a balance of several different types of investments etc… I think mutual funds are great for people that are looking to invest in an investment vehicle that will allow them the opportunity for large gains without taking too much risk. The other benefit of mutual funds is they are run by professional investors who generally have a proven track record of performance. Mutual funds are riskier than CD’s or passbooks accounts but not as risky as investing in individual stocks. I group passbook accounts, credit union accounts and savings bonds in similar categories because they all focus on preservation of capital, guarantee an interest rate but don’t always keep pace with inflation. That means you can ultimately end up loosing money even though your principal doesn’t decrease. The theory behind this is if you invest in a low return investment and earn 2% interest but inflation is at 4% then effectively you have lost 2% because your capital’s purchasing power is 2% less. Because of this I think a savings plan that starts with these investment vehicles are ok until you have enough set aside to get involved with other types of investments but as soon as you can graduate to a better earning investment I think you should. Some people have to use these types of investments because they don’t have the discipline to save without payroll deductions. In that case I think a savings plan consisting of these types of investments is better than not having a savings plan at all. In my opinion the 401K is the grand daddy of all investments for most common working people and should represent a large portion of your savings plan. I consider this to be so great because the funds are invested tax free so you earn interest on the un-taxed funds which helps with interest compounding and the doubling of your funds. Many companies match up to 6% of your contribution into the plan which helps to make the fund grow even faster. It is hard to find another investment that can give you this kind of return. For many people this is the only way they will have enough money to survive after retirement. Another benefit of the 401K is you usually get a number of investment options to choose from such as mutual funds, stocks etc… I strongly urge anyone that has this investment available to them to take full advantage of it. You can learn more about 401K’s on the 401K lesson tab.
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