This is the second installment in our series on how individual investors can assess their financial health.
The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals. The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.
To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:
- Expected total cost of goal
- When the money is needed
- Current amount saved for the goal
- Expected annual rate of saving towards the goal
- How much risk to take in investing to meet the goal
A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator. This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire. The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds. The calculator scales income from your current age forward, based on historical average rates of wage growth.
The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65. The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).
The final output of this model is a projected savings rate that is required for you to meet the target amounts of income. If this is less than you currently save, you are ahead of the game.
There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state. There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university. estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year. This includes tuition, room, board, books and other incidentals. It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year. The University of Chicago has an all-in cost of $64,000 per year. Yale comes in at $58,500.
Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets. There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC. There are also scholarships, of course.
College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades. With inflation currently at about 2%, the expected annual increase in college costs is 6%.
To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs. Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years. In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future. You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.
Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving. If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.
Buying a Home
A house is a major financial commitment—one of the most significant that most people make. Unlike retirement or education, there is an alternative that provides the same key benefits: renting.
For people who decide to buy, a key issue is how much to save for a down payment. The amount that a lender will require depends on your income, credit score, and other debts. Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.
In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home. By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down. A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.
There are several alternatives for investing a down payment fund. The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs. If you are committed to buying a house within one to three years, you really cannot afford to take on much risk. If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk. There is no single answer for everyone.
If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.
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- Goldman Sachs Predicts 4.5% 10-year Treasury Notes
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