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Why Saving Matters : The First Step to Financial Success

 

What is saving?

  • Saving is setting aside a portion of your income instead of spending it, so you can use it later. It’s the act of not using all your money today to ensure you have some for future needs. For young people just starting out with their first job, this money can come from various sources:

  • Earnings from Work: Set aside a portion of your paycheck, even if it’s a small amount. Start with a goal of saving a specific percentage, like 10% of your earnings. However, as a teenager living at home with minimal expenses, you have the ability to save much more than just a small portion of your paycheck. Without the financial responsibilities of adulthood, you can aim to save a substantial percentage of your earnings, well beyond the typical 10%. This is a unique opportunity to build a strong financial base early on. We’ll explore this in more detail in the following sections.

  • Gifts and Allowances: If you receive money for birthdays, holidays, or as an allowance, consider saving a part of it instead of spending it all.

  • Side Jobs or Hobbies: If you earn extra money from side jobs like babysitting, tutoring, or selling crafts, use a portion of these earnings to boost your savings.

 

By identifying different sources of income and setting aside a part of it, you can build a habit of saving early on, which is the first step towards financial independence.

 

Why is Saving Important?

 

  • Preparing for the Unexpected: Life can throw surprises your way - emergencies like car repairs, medical bills, or even a broken phone. Having savings protects you from having to borrow money or go into debt to cover these. We will cover avoiding debt in detail in later sections.

  • Achieving Financial Goals: Whether it’s saving for something fun, like a new phone or a trip, or something important, like education, your savings help you reach your goals without financial stress

    • Short-term Goals: e.g., buying a bike, attending a summer camp.

    • Long-term Goals: e.g., college education, buying a car, building an investment portfolio.

    • Building financial Freedom Through Good Habits: By building the habit of saving regularly, you create the foundation for financial independence. Consistent saving gives you the freedom to make choices, take opportunities, and feel secure.

 

Foundation for Investing

  • Passive Growth Potential: Saving is the first step towards investing, where your money works for you to generate more money.

  • Introduction to Investing: Saving provides the capital needed to start investing, which will be discussed in detail later.

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Introduction to the Seven Types of Income

Our education system often emphasizes earning a salary as the primary way to make a living, leaving out the many other paths to financial growth. In this section, we'll explore the seven types of income, providing a broader perspective on how wealth is built and opportunities beyond a traditional paycheck. Understanding these income streams is a key step toward diversifying your earnings and achieving financial independence.

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Earned Income:

  • This is the most common type of income. It comes from working a job or running a business. People are paid a salary, wages (usually hourly), or commissions in exchange for their time and skills.

  • The most common type of earned income is an hourly wage, where you are paid a specific dollar amount for each hour you work. This structure directly ties your income to the amount of time you spend on the job. For example, working more hours typically increases your earnings, while fewer hours result in lower pay. Hourly wages are common in jobs where schedules may vary, such as retail, hospitality, and part-time work, and they provide a straightforward way to calculate income based on time worked. To estimate your annual salary, multiply your hourly rate by 2,000 (or simply double the hourly rate and add two zeros). For example, earning $24/hour would result in approximately $48,000 per year: 24×2000=48,000

    • Example: Sophie earns $16 per hour from her part-time job as a restaurant hostess. If she worked full-time hours (40 hours per week), her annual income would be approximately $32,000.

  • Salary plus Commission is a type of income structure that combines the stability of a fixed salary with the potential for additional earnings based on performance. The base salary ensures a consistent income, while commissions reward effort and success, providing an incentive to exceed sales targets. Jobs with this structure, such as sales roles, often offer greater earning potential for those willing to put in the extra effort.

    • Alex works as a sales representative and earns a base salary of $40,000 per year. In addition to their salary, Alex receives a 5% commission on all sales they make. If Alex generates $200,000 in sales over the year, their commission would be: 200,000×0.05=10,000 

    • Adding this commission to their base salary, Alex’s total annual income would be $50,000.

 

Profit Income:

  • Profit income is earned by selling goods or services for more than their cost to produce or acquire. It represents the difference between revenue (what you sell something for) and expenses (what it costs to create or provide it). This type of income is typically generated from operating a business, whether it's a full-time venture or a side hustle. Examples include running an online store, offering freelance services, or even flipping items for a higher price. Profit income rewards creativity, efficiency, and entrepreneurship, as it depends on your ability to add value and manage costs effectively.

    • Example: Sophie makes and sells homemade bracelets online, generating profit income from her sales. Each bracelet costs her $0.50 to make, including materials and packaging. She sells each bracelet for $2.00 earning her $1.50 per bracelet in profit income.

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Interest Income:

  • Interest income is earned by lending money to others or allowing institutions to use your money, typically through savings accounts, bonds, or loans. In exchange, the borrower or institution pays you interest—a percentage of the amount borrowed—as compensation for the use of your money. For example, when you deposit money in a savings account, the bank uses it to issue loans and pays you interest in return. Similarly, when you purchase bonds, you are lending money to a government or corporation, and they pay you interest periodically until the bond matures. Interest income is a passive form of earning and can grow over time, especially when combined with compounding, where interest earns additional interest.

    • Example: Sophie puts part of her savings in a high-interest savings account and earns interest on it. She puts $1,000 into a high-interest savings account that offers an annual interest rate of 1%. This means the bank pays her interest for allowing them to use her money.

    • Sophie earns $10 in interest after one year. If she keeps the money in the account without withdrawing the interest, it will start earning interest as well. For example, in the second year, her account balance would be $1,010, and her new interest would be: $10.10

    • This is an example of compounding interest (covered later in this course), where Sophie earns interest not only on her original savings but also on the interest she’s already earned. Over time, this helps her money grow faster.

 

Dividend Income:

  • This type of income is earned by owning shares of a company that pays a portion of its profits to shareholders. These payments, called dividends, are typically distributed on a regular basis (e.g., quarterly or annually) as a reward for investing in the company. Dividend income is a form of passive income and can be reinvested to purchase more shares or used as a source of cash flow. Companies that pay dividends are often well-established and financially stable, making them attractive to investors seeking steady income. Examples include blue-chip stocks or dividend-focused exchange-traded funds (ETFs). Examples:

   1. Blue-Chip Stock:

  • Coca-Cola (KO): Coca-Cola is a globally recognized brand with a strong track record of paying consistent dividends, making it a popular choice among dividend investors.

   2. Dividend-Focused ETF:

  • Vanguard High Dividend Yield ETF (VYM): This ETF focuses on high-dividend-paying companies, providing investors with exposure to a broad portfolio of stocks that prioritize income generation.

  • Example: Sophie owns 10 shares of Apple Inc. (AAPL), which pays a quarterly dividend of $0.25 per share. Each quarter, she receives: 10 shares x $0.25/share = $2.50. Over a year, this amounts to: $2.50 x 4 - $10.00. Therefore, Sophie earns $10.00 annually from her 10 Apple shares through dividend payments.

 

Rental Income:

  • Rental income is money earned by allowing others to use property or assets that you own, in exchange for regular payments. This typically involves renting out real estate, such as houses, apartments, or commercial buildings, but can also include other valuable assets like equipment, vehicles, or storage space. The owner receives rental payments while maintaining ownership of the property or asset. Rental income can provide a steady cash flow and, in the case of real estate, the potential for long-term appreciation in property value. Successful rental income often depends on factors such as location, demand, and effective management of the property or asset.

  • Example: Sophie’s parents rent out the basement of their family home for $500 per month. Over a year, they earn: 500 x 12 = 6,000. This means Sophie’s parents generate $6,000 annually in rental income, which they can use to cover household expenses, save, or invest. This example highlights how even a single rental opportunity can provide consistent extra income.

 

Capital Gains:

  • Capital gains income is the profit earned when an asset, such as stocks, real estate, or a business, is sold for more than its purchase price. The difference between the selling price and the original purchase cost is considered the capital gain. Capital gains can apply to a wide range of assets, including investments, property, and collectibles.

There are two types of capital gains:

1. Short-term capital gains: Earned when an asset is held for one year or less before being sold. These gains are typically taxed at a higher rate, similar to ordinary income (more on this later). 

2. Long-term capital gains: Earned when an asset is held for more than one year. These gains are taxed at a lower rate, encouraging long-term investment.

 

Capital gains income is an important aspect of wealth-building and is often realized as part of a broader financial strategy. However, it's essential to consider taxes and other costs, such as transaction fees, which may reduce the overall profit.

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  • Example: Sophie purchased 10 shares of AAPL at $130 per share. The current market value of her shares is $225 per share. If she decides to sell, her capital gain per share would be: Capital Gain per Share = Selling Price - Purchase Price or 225 - 130 = 95. For all 10 shares, her total capital gain would be : 95 x 10 = 950. If Sophie held the shares for more than one year, this would be considered a long-term capital gain, potentially subject to lower tax rates. This example shows how investing in assets like stocks can generate significant profits over time.

 

Royalty Income:

  • Royalty income is earned by granting others the right to use your intellectual property, such as patents, trademarks, copyrights, or other creative works, in exchange for regular payments. This type of income is commonly generated from assets like books, music, art, films, inventions, or even software. The payments, known as royalties, are typically structured as a percentage of the revenue earned from the use of the intellectual property or as a flat fee.

Royalty income is often passive, as it continues to generate revenue over time without requiring additional work once the property is created and licensed. It provides a way for creators and innovators to monetize their efforts and benefit from the ongoing value of their intellectual property.

  • Examples:

  • A musician earns royalties each time their song is streamed, played on the radio, or used in a commercial.

  • An author receives royalties from book sales.

  • An inventor earns royalties when a company uses their patented technology.

  • Example: Sophie creates a YouTube channel where she uploads original videos. Her content grows in popularity, and she starts earning ad revenue through the YouTube Partner Program. Her videos receive 1,000 views per month, and YouTube typically pays creators between $0.01 and $0.03 per view, depending on the type of ads shown and the audience location.

  • To estimate Sophie's monthly earnings: 

    • Lower Estimate: 1,000 views x $0.01 = $10.00

    • Higher Estimate: 1,000 views x 0.03 = $30.00

  • Sophie earns between $10.00 and $30.00 per month from ad revenue. Over the course of a year, this amounts to $120.00 to $360.00.

  • Explanation: As Sophie's viewership grows, so does her potential royalty income from YouTube ads. If she continues creating engaging content and attracting more viewers, her revenue would increase significantly, making this a scalable source of royalty income.

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