Managing Your Money Chapter 10

Earning Interest

How Your Money Grows Principal – amount of money deposited by a saver Interest - money paid for the use of money; earnings on a savings acct. Compound Interest – interest computed on the original principal plus the accumulated interest

Compound Interest Interest can be compounded daily, monthly, or annually. Not all savings accounts are created equal! Let’s see why.

Three factors affecting the time value calculations Time Amount invested Interest rate

Time value of money Time value of money -- Money to be paid out or received in the future is not equivalent to money paid out or received today.

Compounding interest Compounding interest -- Earning interest on interest. “Make your money work for you.” Developed because compounding interest causes money to make money. $1,000 Invested Compounded Annually at 10% Interest Rate 1 Year2 Years $1,104.71$1,220.39

Simple interest Simple interest -- Interest earned on the principal investment. Principal -- The original amount of money invested or saved. Amount invested x annual interest rate x number of years = interest earned. Ex. 1,000 x 0.10 x 2=$200 $1,000 Invested at 10% Simple Interest Rate 1 Year2 Years $1,100.00$1,200.00

Time The earlier an individual invests, the more time their investment has to compound interest and increase in value.

A little goes a long way Sally Saver puts away $3,000 per year in her IRA account earning 10% - she does this for 10 years then stops Sally accumulates $1,239,564 by the age of 65.  Ed Uninformed waits until he is 28. He must contribute $3,000 to his IRA account earning 10% for 38 years.  Ed accumulates $1,102,331 by the age of 65.

Amount invested Investing only a small amount a month is better than not investing at all. Ex. At 8% interest, invested at age 17, one dollar per day will become $17, by age 65. The larger the amount invested the greater return a person will earn. Always pay yourself first. Savings should be a fixed expense.

Amount invested continued Rule 70% Spent 20% Saved 10% Invested Flexible expenses can be decreased in order to increase the amount a person is able to invest.

The costs add up ItemAverage Yearly Expense Future Value Eating lunch out 5 days per week at a cost of $5-$10 each time $1, $2,600.00$55, $110, Daily candy bar$365.00$15, Monthly gym membership at $38.00 $456.00$19, Monthly hair cut at $25.00 per month $300.00$12,  The future value problems are calculated for an 18 year old person investing at 8% until age 65.

Interest rate The percentage rate paid on the money invested or saved. Higher interest = more money earned $1,000 Invested Compounded Monthly Interest Rate 1 Year5 Years10 Years 4%$1,040.74$1,221.00$1, %$1,061.68$1,348.85$1,819.40

Risk A higher interest rate generally has a greater risk. Risk -- The uncertainty of the outcome of an investment.

Fixed interest rate Fixed interest rate -- The rate will not change for the lifetime of the investment. Having a savings or investment plan with a fixed interest rate guarantees a specific return but can provide a moderate risk. If the average interest rates rise, the amount a person earns from this type of investment will not increase.

Inflation Another consideration with interest rates is ensuring the interest rate is higher than the rate of inflation. Inflation -- The steady rise in the general level of prices. Ex. If an individual has money invested at 4% interest and the inflation rate is 4%, the individual’s wealth will stay the same.

Time value of money calculations I = PRT Present value PV=(FV)(1+i) -N Future value FV=(PV)(1+i) N Step 1: Principal X Interest Rate (in decimal form) X Time Periods = Interest Earned Step 2: Principal + Interest Earned = Amount Investment is Worth

Simple Interest Example $1,000. at 5% for 3 years $1,000 x.05 x 3 = $ interest $1,000 + $150 = $1,150.00

Compound Interest Example $1,000. at 5% for 3 years $1,000. x.05 x 1 = $1,050. x.05 x 1 = $1, x.05 x 1 = $1, ($ interest )

Calculation components Present value (PV) -- How much money a person has today. Future value (FV) – How much money a person expects to have in the future. Interest rate (i) – The percentage rate paid on the money invested or saved. Time (N) -- Length of investment Calculated by the number of compounding periods. (daily, monthly, or annually)

Review Compounding interest earns interest on interest. Increased time=more interest earned Higher principal=more interest earned Higher interest rate=more interest earned

What would you do? $ Invested at an 8% interest rate AgeAmount Earned 17$ $ $ $ $2, $4,  If participants choose to invest the money into an account earning 8% interest compounded annual at age 17 and leave the money invested until age 65, they will earn $4,

What would you do? $ Invested at an 8% interest rate AgeAmount Earned 17$ $ $ $ $ $1,  What if the participant chooses to invest $30.00?

Compound Interest 5 Years10 Years No Interest $1,000. Annual Compounding at 5% $1,276.$1,629. Monthly Compounding at 5% $1,283.$1,647. Daily Compounding at 5% $1,284.$1,649.

Saving $1 a Day No Interest5% Daily Compounding Year 1 $365$374 Year 5 $1,825$2,073 Year 10 $3,650$4,735 Year 30 $10,950$25,415

How your money grows Earnings on savings can be measured by the rate of return or yield YIELD – percentage of increase in the value of your savings due to earned interest (APY) --takes compounding into consideration also allows consumers to compare rates among banks

Rule of 72 72=Years to Interest Rate double investment (or debt) The answers can be easily discovered by knowing the Rule of 72 The time it will take an investment (or debt) to double in value at a given interest rate using compounding interest.

Albert Einstein “It is the greatest mathematical discovery of all time.” Credited for discovering the mathematical equation for compounding interest, thus the “Rule of 72” T=P(I+I/N) YN

What the “Rule of 72” can determine How many years it will take an investment to double at a given interest rate using compounding interest. How long it will take debt to double if no payments are made. The interest rate an investment must earn to double within a specific time period. How many times money (or debt) will double in a specific time period.

Things to Know about the “Rule of 72” The “Rule of 72” Is only an approximation The interest rate must remain constant The equation does not allow for additional payments to be made to the original amount Interest earned is reinvested Tax deductions are not included within the equation

Doug’s Certificate of Deposit Invested $2,500 Interest Rate is 6.5% 72=11 years to double investment 6.5% Doug invested $2,500 into a Certificate of Deposit earning a 6.5% interest rate. How long will it take Doug’s investment to double?

Another Example The average stock market return since 1926 has been 11% Therefore, every 6.5 years an individual’s investment in the stock market has doubled 72=6.5 years to double investment 11%

Jessica’s Credit Card Debt $2,200 balance on credit card 18% interest rate 72=4 years to double debt 18% Jessica has a $2,200 balance on her credit card with an 18% interest rate. If Jessica chooses to not make any payments and does not receive late charges, how long will it take for her balance to double?

Another Example $6,000 balance on credit card 22% interest rate 72=3.3 years to double debt 22%

Jacob’s Car $5,000 to invest Wants investment to double in 4 years 72=18% interest rate 4 years Jacob currently has $5,000 to invest in a car after graduation in 4 years. What interest rate is required for him to double his investment?

Another Example $3,000 to invest Wants investment to double in 10 years 72=7.2% interest rate 10 years

Rhonda’s Treasury Note 72= 9.6 years 7.5%to double investment AgeInvestment 22$2, $5, $10, $20, $40,000 70$80,000 Rhonda is 22 years old and would like to invest $2,500 into a U.S. Treasury Note earning 7.5% interest. How many times will Rhonda’s investment double before she withdraws it at age 70?

Another Example $500 invested at age 18 7% interest How many times will investment double before age 65? 72=10.2 years 7%to double investment AgeInvestment 18$ $1, $2, $4, $8,000 69$16,000

Taxes A person can choose to invest into two types of accounts: Taxable Account – taxes charged to earned interest Tax Deferred Account – taxes are not paid until the individual withdraws the money from the investment

Taxes Example George is in the 33% tax bracket. He would like to invest $100,000. George is comparing two accounts that have a 6% interest rate. The first is a taxable account charging interest earned. The second account is tax deferred until he withdraws the money. Which account should George invest his money into?

Effects of taxes YearsTaxableTax Deferred 12$200,000 18$200,000 24$400,000 36$400,000$800,000 Taxable Account Earning 4% after taxes 72=18 years 4%to double investment Tax Deferred Account 72=12 years 6%to double investment

Conclusion The Rule of 72 can tell a person: How many years it will take an investment to double at a given interest rate using compounding interest; How long it will take debt to double if no payments are made; The interest rate an investment must earn to double within a specific time period; How many times money (or debt) will double in a specific time period.

Conclusion continued Things individuals must remember about the Rule of 72 include: Is only an approximation The interest rate must remain constant The equation does not allow for additional payments to be made to the original amount Interest earned is reinvested Tax deductions are not included within the equation

WHERE You Can SAVE COMMERCIAL BANKS -- widest variety of banking services  Checking  Savings  ATM’s  Overdraft protection  Loans Almost all insured by FDIC

FDIC The standard insurance amount of $250,000 per depositor is in effect through December 31, On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except IRAs and other certain retirement accounts, which will remain at $250,000 per depositor.

WHERE You Can SAVE SAVINGS BANKS Usually referred to as mutual savings banks - fewer in number  Savings  Real Estate Loans  Home-improvement Loans  Checking accounts

WHERE You Can SAVE SAVINGS & LOAN ASSOCIATIONS Organized primarily to lend money for home mortgages  Checking accounts  Special Savings  Business loans  ATM’s / credit cards  Many today have merged with Banks

WHERE You Can SAVE CREDIT UNIONS Not-for-Profit organizations established by groups of employees in similar occupations who pool their money -- higher interest rates on savings -- lower interest rates on loans -- IRA’s -- checking accounts, CD’s

WHERE You Can SAVE CREDIT UNIONS Owned by their members – must be a member of the group SHARE ACCOUNT – savings account at a credit union Provides insurance up to $100,000

New NCUA Rules for Insurance Coverage Temporary increase in basic NCUA insurance amount Effective October 3, 2008, the basic limit on federal share insurance coverage has been temporarily increased from $100,000 to $250,000 per member. The legislation provides that the basic share insurance limit, or standard maximum share insurance amount, for most types of accounts will return to $100,000 after December 31, 2013.

WHERE You Can SAVE BROKERAGE FIRMS SECURITIES – stocks, bonds issued by corporations or by the gov’t. STOCKS = equity BONDS = debt STOCKBROKER – a licensed employee of a brokerage firm who buys/sells securities for investors

SAVINGS OPTIONS REGULAR SAVINGS ACCOUNT Major advantage - high liquidity free to make deposits/withdrawals ATM card available LIQUIDITY – ability of an asset to be converted into cash quickly without loss of value Disadvantage - pays least amount of interest of the savings options Monthly fee assessed if balance falls below a minimum amount

WHERE You Can SAVE CERTIFICATE OF DEPOSIT (CD) a/k/a time deposit – earns a fixed interest rate for a specified length of time -- requires a minimum deposit -- interest rate slightly higher than Savings (less liquid) -- penalty for early withdrawal

Cash Management The daily routine of handling money to take care of individual or family needs Cash Management

Effective cash management includes having available money for: Living expenses Emergencies Savings Investing

Cash Management Tool A financial account used to assist with daily cash management Checking Account Savings Account Money Market Deposit Account Certificate of Deposit Savings Bond Five types of cash management tools

Checking Account Tool used to transfer funds deposited into an account to make a cash purchase Checking accounts may be non- interest or interest earning Checking Account

Funds are easily accessed by: Checks Automated teller machines (ATMs) Debit cards Telephone Internet Features may include: Minimum balance requirements Charge transaction fees Limited number of checks written monthly Reduces the need to carry large amounts of cash Checking Account continued

Savings Account Account to hold money not spent on consumption Interest bearing Have a lower interest rate than other cash management tools Money may be accessed or transferred between accounts through: Automated teller machines Telephones Internet

Savings Account continued Features may include: Allows for frequent deposits or withdrawals Easily accessible Money storage for emergencies or daily living Available at depository institutions May require a minimum balance or have a limited number of withdrawals

Money Market Deposit Account A government insured account offered at most depository institutions Have a minimum balance requirement with tiered interest rates The amount of interest earned depends on the account balance For example: a balance of $10,000 will earn a higher interest rate than a balance of $2,500

Money Market Deposit Account continued Accessibility is usually limited to three to six transactions each month Features of may include: Minimum amount required to open the account, often $1,000 If the average monthly balance falls below a specified amount, the entire account will earn a lower interest rate Checks written – minimum $250.00

Certificate of Deposit (CD) An insured, interest earning savings instrument with restricted access to the funds Found in depository institutions accepting deposits for a certain length of time Interest rates vary depending upon specified time length The longer the length, the higher the interest rate

Certificate of Deposit continued Features may include: Range from seven days to eight years in length Minimum deposits range from $100-$100,000 If funds are withdrawn before the expiration date, penalties are assessed Low risk and no fees

Savings Bond Discount bond purchased for 50% of the face value from the U.S. Government Interest earned on a bond is tax exempt until redeemed. No taxes are due on interest earned It will be tax exempt when redeemed if used for college expenses

Savings Bond continued Access to funds is restricted Features of may include: Many different types available Can be purchased for $ $10, A $ bond would be purchased for $ When the bond matures to $100.00, it can be redeemed

Cash Management Tools Tool Average Interest Earned Purchase PlaceSpecial Features Checking Account 1.5% Commercial Banks, Savings & Loan Associations, Credit Union Can be used in place of cash, funds can be easily accessed Savings Account 2.3% Commercial Banks, Savings & Loan Associations, Credit Union Easily accessed, temporary holding place for funds Money Market Account 2.6% Commercial Banks, Savings & Loan Associations, Credit Union Minimum balance, limited transactions, tiered interest rates Certificate of Deposit 4.0% - 5.4%, depending on the length of deposit Commercial Banks, other institutions which accept deposits for a fixed period Penalties for early withdrawals, no deposits or withdrawals are made after initial investment Savings Bonds 4.0% - 5.4%, depending on the length of bond Commercial Banks, Credit Unions, employer payroll deduction plans Tax advantages, a loan to the federal government

Liquidity How quickly and easily an asset can be converted into cash Investors should: Invest in both liquid and non-liquid tools Liquid assets are important for emergencies when cash must be quickly accessed Cash management tools are protected by the U.S. Government against loss Liquidity

Checking Account Savings Account Money Market Deposit Account Certificate of Deposit Savings Bond Most Liquid Least Liquid

Low Risk These five cash management tools are low risk: Insures the funds so the consumer does not lose money on the investment However, they have lower interest rates Causes low returns

Speculation Growth Safety and Income Financial Security (Cash Management Tools) Investment Risk Pyramid Growing risk to investor’s capital Increasing safety of principal Growing risk of loss of purchase power Increasing potential for higher returns

Summary Cash management is a daily routine of handling money to have enough funds for: Living expenses Emergencies Savings Investing

Summary Five types of cash management tools: Checking account Savings account Money market deposit account Certificate of deposit Savings bond

What are some personal factors that help determine the amount of money you will save? NAME 4 (a) amount of discretionary income, (b) the importance you attach to savings, (c) anticipated wants and needs, (d) will power or ability to forego present spending in order to provide for your future

Why might people choose to save their money in a commercial bank when another type of financial institution offers a higher interest rate? People choose commercial banks mainly because of the many services they offer C O N V E N I E N C E !

Is a credit union “for profit” or “not for profit”? Credit unions are not-for-profit organizations established by groups of employees in similar occupations who pool their money.

Why types of loans do savings and loan associations primarily provide for their customers? Savings and loan associations are organized primarily to lend money for home mortgages.

How much is an account insured for by the FDIC? Accounts are insured for up to $250,000 per depositor per financial institution

Why does a regular savings account pay less interest than a certificate of deposit? A regular savings account has complete liquidity; therefore, the interest rate is low.

What FOUR (4) things should you consider when choosing a financial institution for your savings? (a) safety, (b) liquidity, (c) convenience, (d) interest earning

Describe two (2) ways you can force yourself to save. (a) automatic deductions (b) savings clubs

If two savings accounts offered 5 percent interest, but one was compounded quarterly and other was compounded daily, which account would have the higher APY? The more often interest is compounded, the greater your earnings. You earn more interest with quarterly compounding than with annual compounding, and more interest with daily compounding than with quarterly compounding.