How Much To Save
Saving for long-term goals requires putting money aside on a regular basis so that after several years you have enough to spend on what you want. How much money do you have to save each month to buy a car or to go on your dream vacation? If you save $100 per month will you have enough to buy the item you want? There are several approaches that we can use to determine how much to save and how long it will take.
Basic Savings
The basic savings approach simply entails dividing the purchase price of the item by the number of months you plan to save for that item. So if the purchase price is $7200 for a vacation you plan to take in 3 years then you would need to save for 3 X 12 = 36 months while the amount to save is $7200 / 36 = $200 per month. But what if prices increase, as they inevitably do? Then you need a modified approach to determine the amount to save.
Inflation Savings
The inflation savings approach takes the effect of price inflation into account in determining how much to save for your planned purchase. If prices are increasing 2% per year and the current price of the vacation is $7200, then the price 3 years from now will be $7200 X 1.0612 = $7641. So you need to save more than just $200 per month, namely $7641 / 36 = $212.25 per month. But what if you earn interest on your savings? That should reduce the amount you need to save each month.
Interest & Inflation Savings
If you earn interest on your savings then adjust the total amount you will have to spend by adding the interest earned. So if you have a savings account earning a rate of interest (r) per year, compounded monthly, then one way to estimate the total amount of the account balance at the end of the time period, say 3 years for your planned vacation, when you deposit an amount S each month is Total Saved (TS) = S X 36 + S X r X 3 X 35/2. For r = 4%, the Total Saved is S X 38.1, so for an inflated vacation price in 3 years time of $7641 you need to save S = $7641 / 38.1 = $200.55 per month. The actual amount is a little less than this due to the effect of compounding where interest earns interest too.
Saving for a Down Payment
For expensive purchases one often saves for a down payment rather than the total purchase price and borrows the rest of the money. Some examples are buying a home with a 20% down payment and a mortgage for the remaining 80% or buying a car with 10% down and a car loan. Trying to save for the total price of a home, such as $300000, would typically take many years. When real estate prices are increasing over many years, by the time the required amount is saved one finds that the new price for the home is much higher, say $500000. In such cases, saving for just the down payment allows one to buy the home earlier at a lower price while at the same time increasing their home equity due to increasing home prices.
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