While I have covered topics such as gift-giving for kids and how to live more like a kid, I haven’t discussed much about saving for children’s education. Nate’s post is a perfect addition to cover some of the financial benefits of starting to save early for college by using the power of compounding interest.
The following is a guest post by Nate Matherson, co-founder of a personal finance site called LendEDU, and an about-average millennial working to repay over $50k in student loan debt. LendEDU originally launched as a site focused on financial aid, including student loan debt, but has since expanded into a wide variety of topics.
The Rising Costs of College
College Board found the cost of college topped $25,000 per year for a four-year degree at a state school as a resident and costs exceeded $50,000 annually for students attending private not-for-profit schools. This means a four-year degree could run more than $200,000 – which is an insane amount of money.
If you have kids, you know college costs are only going up – and chances are good you don’t want to saddle your son or daughter with huge student loans in the future. Moreover, you don’t want to become one of the many parents on the hook for repaying that debt as a cosigner on a private student loan.
The good news is, if you start saving for college for your kids early, you can actually amass a pretty big pot of cash to cover school costs by the time your children reach college age – without investing a huge amount. You can do this thanks to the magic of compound interest. But, for this to work, you need to start when your kids are as young as possible.
Why It’s Important to Start Saving for College Early
When you have a ton of money to save, starting ASAP is essential because your investments can grow exponentially once you get started.
As you invest, your investments will earn returns. These returns make your pot of invested money bigger – and soon, you’ll earn returns not just on the cash that you put into the count but also on the money that has amassed in the account thanks to the growth of your investments.
When the money you earned in investment returns is added to your pot of investments and you then earn returns on that cash, this is called compounding. And, over many years of investing, it’s shocking how much compounding can help your total wealth to grow.
How Does Compounding Work
The best way to understand the power of compounding is to look at a simple account that pays you 5% interest compounded monthly.
Let’s say you put $1,000 into that account. At the end of the first month, after you put the money in, any interest earned during the course of that month would be added to the principal balance. This happens since interest is compounded – or added to the principal – each month.
Since your annual interest rate in this example is 5%, you’d earn 5%/12 months or around .417% per month. Your $1,000 would get you around $4.17 during the first month you’re invested — so you’d end the month with $1,004.17.
Next month, you’d earn another .417% on your invested money – but you’d earn it on $1,004.17 instead of on $1,000. So you wouldn’t get $4.17 in interest, you’d get about $4.19. You’d end the month with $1008.36. Then, next month you’d make .417% on $1008.36… and each month the invested balance you earn interest on would keep getting bigger so you’d earn a little more extra interest.
This Compound Interest Calculator from the U.S. Securities and Exchange Commission is pretty handy for doing your own analysis!
Maximizing Returns Helps Your Money Compound Faster
As you can see, compound interest makes a big difference because your pot of money grows each month even if you don’t add additional cash — and then you earn bigger returns thanks to the fact you have more money invested.
Investment returns can compound daily, monthly, or yearly depending on what you’re invested in. The more frequently your money compounds, the bigger the amount of money invested, and the higher your rate-of-return, the more compounding power, which will help your wealth to grow.
Because higher returns on investment will mean your money grows even faster, it’s a good idea to invest your money in the stock market when you’re saving for college. The stock market has proven to consistently provide higher annual returns over time than other investments such as real estate, bonds, certificates of deposit, or savings or money market accounts. And, if you build a diversified portfolio, you can minimize the risk while maximizing the chance you’ll earn good returns.
Picking individual stocks is often too complicated for investors simply looking to grow a college nest egg but putting your money into index funds is an affordable and relatively safe way to get your cash into the market. Index funds track different financial indexes – for example, you could buy a fund that tracks the performance of the Dow Jones Industrial Average or that tracks the performance of large companies (large caps) or small companies (small caps).
Where to Invest for College
As your money grows, you’re usually taxed on gains. The good news is, if you invest in a 529 account for college, your money can grow without incurring any federal tax liability. And, most states also allow money invested in a 529 account to also grow tax-free. This means that when you earn a return on investment, you don’t lose any portion of your gains to the government in the form of paying a big tax bill.
There are rules for 529 accounts – you have to use the funds to pay for school to get the tax breaks. But, as long as your son or daughter will definitely go to college, putting money into a 529 early and investing in index funds could be the key to helping them afford to go to school debt free.
Just remember, start saving for college ASAP when your child is born (or even before!) so compounding power can work to help your money grow.