Saving and Investing for Education, Housing, and Retirement Goals

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.

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.

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.

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.

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.