How Much to Save Each Month
The last part of the equation is to figure out how much money the parent needs to put away each month over the next eighteen years to arrive at the $45,704 figure. The first variable to assess is the interest rate the money will accrue over the next eighteen years. Certainly, the parent could place the money in a non-interest bearing savings account but given the length of time until the money is needed, far less needs to be put away each month if the money earns even a little interest. It is beyond the scope of this article to discuss these options in detail, but many banks offer savings accounts specifically designed for those saving for college. Parents may opt to invest in Certificates of Deposit, 529 plans, or other investment opportunities. For our purposes here, let us assume that whatever investment plan the parent chooses, it is expected to pay 5% APR with monthly compounding. If the interest rate is quoted as an APY, a conversion to an APR must be calculated.
The simple future value formula above assumes that the college tuition is needed all at once. In contrast, monthly saving can be thought of as an annuity payment because a fixed amount of money is continually paid into some investment, and previous interest earns interest in subsequent periods. Therefore, we can use the future value of an annuity formula to calculate the monthly payment needed to save $45,704 over eighteen years at 5% APR interest. The future value of an annuity formula is given as:
FVA = CF * [(((1 + r)n) – 1) / r]
Where FVA is the future value of the annuity, CF is the recurring cash flow (monthly saving), r is the interest rate, and n is the number of periods. In this case, the cash flow is the amount that needs to be saved each month. Also, since interest is calculated monthly, the number of periods will be 216 (18 * 12) since the parent will be contributing to the college fund 216 times over the next eighteen years. We also need to divide the annual interest rate by 12 to find the monthly interest rate. In this case, the monthly interest rate is 0.004167 (0.05 / 12). Using the formula above, we find that:
45,704 = CF * [(((1 + 0.004167)216) – 1) / 0.004167]
45,704 = CF * 349.20
CF = $130.88
So, the parent must put away $130.88 per month for the next 216 months (eighteen years) at an interest rate of 5% APR to save the $45,704 needed for the child’s education. Notice that because of the interest earned, the parent only needed to actually save $28,270.08 (130.88 * 216). The remaining $17,434.92 was the result of interest! As you can see, the power of compounding interest makes saving early for college worthwhile.