Wednesday, February 11, 2009

Don't Be Scared Of Investment Terms You Don't Understand - Part 1

Saving Money Tip #67 - Don't Be Scared Of Investment Terms - Part 1. Some people hear financial words tossed around - mutual funds, CDs, money markets, stocks, bonds, compound interest, FDIC, brokers, etc. and they don't understand these investment terms and therefore think they should not invest money. This is not the case. I'm going to explain some of these terms so there is less fear and more understanding. Investing money is just putting money away to make more money. And as we have discussed in the past, everyone should be putting money away. As you put money away over time you will become more knowledgeable and learn first-hand what some of these investment terms are and become more comfortable investing in different things.

Savings account is the first investment term we will discuss. Most of us know what a savings account is. A bank or credit union holds our money for us and gives us interest (a percentage of our money) for the privilege of keeping it for awhile. A typical savings account today may pay 1%-2% interest annually (yearly). That means if you put $1,000 in a savings account on January 1, then on December 31 of that year you will have$1,020 if the bank is giving you 2% annual interest. The bank has given you $20 in interest for the year ($1,000*.02 =$20).

Savings accounts are easy to understand and most of us are familiar with them. The savings account should be the first place where you start putting your money away. The beauty of the savings account at your bank or credit union is that there is virtually no risk to putting money in them. The account you have there is guaranteed by the Federal Deposit Insurance Corporation (FDIC). In other words, if the bank your money is put away in goes under, the FDIC will still give you the money that is owed you. This is true if you have as much as $100,000 in your account. Savings accounts are your least risky investment, and most people are comfortable with them.

Compound interest is not complicated. Compound interest is essentially interest on your interest. And it is this compound interest that makes saving money grow so fast. Many people in the financial field talk about the "magic of compound interest" because compounding interest builds up savings more quickly. Let's look at our previous example. At the end of year 1 you have $1,020. Assuming you don't put anything else in your account, at the end of year 2 you will have $1,040.40. The first year you earned $20 on your savings amount of $1,000 but at the end of the second year you earn an additional $20 and 40 cents. That is you are earning $20 interest on the initial $1,000 you put in plus you are earning 40 cents interest on the $20 interest you earned the previous year. That 40 cents is the compound interest (the interest on your interest). If there was no compounding interest then you would just have $1,040.

At the end of year 3 you will have $1,061.21. That is, you earn an additional $20 on the initial $,1000 you put in. Plus you earn 2% on your interest. Your interest at the beginning of the year was $40.40. You multiply that by the 2% interest rate ($40.40*.02) and you get 81 cents (.808) interest on your interest. So now you have $1040.40 from last year + $20 interest this year from the initial $1000 + 81 cents interest this year from the interest on $40.41 for a total of $1,061.21. Without compounding interest you would only have $1,060 at the end of year 3.

As the years go by, the interest on your interest keeps building up. At the end of 30 years you would have$1,600 if there was no compound interest. With compound interest you will have $1,811.36, which is why many people say there is magic to compound interest. Results are much more dramatic at higher interest rates and with higher dollar amounts.

Money Market Account is a more sophisticated savings account. It requires a minimum dollar amount and offers a higher interest rate than a savings account. The limits on this account are that you usually must maintain a minimum dollar amount in your account. You are also limited to the number of withdrawals and the dollar amount of the withdrawals. Withdrawals are usually made via checks that you have with the account. The bank pays you a higher interest rate on this account than on a savings account because you are keeping a minimum dollar amount in it. Today the rates may be 2 1/2% or 3% on a money market account. This account is also guaranteed by the FDIC so there is virtually no risk to investing in a money market account.

Certificates of Deposit (CDs) are the last thing we will talk about today. A a certificate of deposit is when you put your money away for a specified term. A certificate of deposit pays more interest than a savings account and usually more than a money market account because you are putting a minimum amount away for a specified term. The bank or credit union that you open a CD with is counting on having a certain amount of money from you for a certain period of time so they are willing to pay you more interest for it. With a savings account you can put in $100 one day then take it out the next week or add $40 to the account the following month. You can essentially take out and add to it whenever you please. And whatever balance is in your account at a given time will earn interest. With a money market account you must maintain a minimum balance and a the amount of withdrawals on the account are limited.

With a CD you put in a certain amount like $,1000 for a given period of time such as 1 year. This means you are lending the bank your $1,000 for one year. You cannot add to the CD or take money out of it or you will be penalized. The bank will give you your $1,000 back at the end of 1 year with interest. Depending on the amount and the term, some CDs today are paying as high as 3%-4%. The certificate of deposit is also covered by FDIC, so you cannot lose your initial investment or the interest. There is virtually no risk to this investment except the risk that you may need the money before the CD comes due or that inflation goes up, and your CD rate is still locked in at a lower rate. However, if you know you will be putting money away for long-term (1 year or 5 years) and you have absolutely no need to touch it before then, a CD is a better option than either a savings account or a money market account as long as you don't think rates will be going up in the near future. There are even short-term CDs such as 6 month ones if you want to park your money there for the short-term for a slightly higher rate than a savings account.

In Real Life (IRL) - I've already talked about opening my first passbook or savings account when I was a kid. I was excited to learn that the bank would be paying me interest to hold my money for me. At the time - in the late 1970s and early 1980s, the rates on savings accounts were about 5% (aahh, the good old days!). As I accumulated more money, my dad convinced me to open up money market account to earn even more interest. I was saving this money for down the road so I really didn't need to access to it. And I still kept some money in a savings account for money I might need. The money market accounts in those days paid 6 or 7% if I remember correctly. This investing was fun! I was hooked.

At some point opened some certificates of deposit for 1 or 5 years, always keeping money in a savings account that I could access if I needed it. It wasn't until I was into my 20s that I started investing in more sophisticated places - such as mutual funds and stocks. We'll discuss those in my next post. Until then, figure out the best investment for the money that you have saved - starting with savings accounts, money market funds, and CDs. These are usually the best places to invest money for beginners. And don't forget to shop around. There can be wide variance of rates among banks and credit unions.

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