Saving means to put some money aside for later use. When your kids are little, you encourage them to put some of their birthday money in their piggy bank. When they get older you may open a savings account for them to deposit some of the money they earn from jobs. It’s the same way for adults. Saving means taking some money and putting it aside for later – maybe saving for holiday gifts or for vacation or for longer-term goals like paying for college, buying a house or saving for retirement. You can save your money at home or you can save money and deposit it in a savings account with a local bank. Investing means taking money that you have saved and using it to buy or participate in a business venture that offers the possibility of profit, or interest. You could invest by taking some of your savings and purchasing a savings bond, buying stock, or depositing money in a certificate of deposit (CD).
To plan ahead for your future, it’s a good idea to making saving a priority. Even if it’s saving just $10 from each paycheck or a little bit of money you get from occasional work or an unexpected check and putting it in a savings account, every little bit counts. Want to know how? Say you save just $20 a month, or $10 from each paycheck (if you get paid twice a month). At the end of one year, you will have saved $240. If you continue saving that same amount for 5 years you will have saved $1,200! Once you begin saving you’ll want to make that money work for you by investing it wisely. Why? Because when you invest money you have the opportunity to earn something called interest.
What is interest?
Interest is a fee. It’s the amount of money you either earn on an investment or the money you owe on a loan. When banks or other financial institutions give you credit, such as when you borrow money to buy a home or a car, they’ll charge you interest, or a percentage of the amount of money you borrow, for using their money. On the other hand, you can also make money by earning interest when you invest your money. Examples of investments where you can earn interest include depositing money in an interest-bearing checking or savings accounts, bonds, Treasury bills or bonds, certificates of deposit, money market funds, stock or bond mutual funds, or individual stocks.
Earning interest on savings
Over the past few years, Oscar has managed to put a little bit of money aside from paychecks, odd jobs, and gifts to save $1,000. Recently he learned that he could deposit money in a savings account at his local bank. He heard that his money would be protected by law and that he would earn interest for opening an account. He deposited his $1,000 in a savings account at ABC bank in an account that earned 3% interest annually. At the end of the year Oscar had earned $33 just for opening the account and leaving his money untouched.
Earning interest on an investment
Laura and Roberto received cash gifts from relatives for their wedding and combined it with some personal savings to accumulate $7,500 in savings. They weren’t ready to settle down right away but knew that they wanted to buy a home in 3 or 4 years. They met with a personal financial advisor and decided to invest $7,500 in a stock mutual fund. The funds’ interest varied each year, but after 4 years they had earned approximately 7% interest annually and saw their original $7,500 investment increase to approximately $9,800.
Paying interest on a loan
Carla and Jose just moved to a new apartment. They could barely afford the monthly rent, but they needed furniture. They charged furniture using a three-year finance plan at a local department store. They ended up charging nearly $5,200 in furniture at an interest rate of 14%. By signing a long-term loan at such a relatively high interest rate they’re actually going to end up paying an additional $1,032 for the furniture. A better idea would have been to get a lower cost personal loan through their bank or company’s credit union, to have borrowed money from family members, or to shop for lower cost, gently used furniture they could afford to pay for in cash.
The biggest loan that most people ever take on is a home mortgage. Say for example that you sign a 30 year fixed rate home mortgage for $50,000 at 10% interest. Your monthly payment will be $439. That means that for 30 years you’ll pay $439 per month for your home loan. Over the life of the loan that 10% interest that you’re paying will add up so that by the time you’ve paid the loan off 30 years later you’ve actually paid the bank $157,965 – more than 3 times the amount you borrowed to buy the home!
Although that sounds like a lot, it’s just meant to demonstrate that interest adds up. One way to is to make even just one additional mortgage payment toward principal on your loan each year. By making that one additional payment toward your principal you can cut the life of your loan by 9 years and save over $38,000 in interest!
What difference does the interest rate make?
Even a small difference in interest rates can make a big difference in how much you’ll owe or you’ll earn. The key is when it comes to debt you want a low interest rate and when it comes to saving and investing you want a high interest rate. In other words, you want to pay the least amount, or find the lowest interest rate when it comes to borrowing money and you want to earn the most, or look for the highest interest rate you can get, when you invest your money. How do you find the highest rate? Ask the loan officer at your local bank how much interest you’ll be charged. If you’re depositing money in a savings account or investing money in instruments like stocks, bonds, or mutual funds, ask how much interest you’ll earn. Take that information and call or drop in to other banks and ask them the same questions. Compare what interest rate you’re offered.
Small differences in the interest rates charged on debt can add up. For example, if you’re buying a home and you’re offered an $85,000 mortgage at 9% your monthly mortgage payment is $684. The same mortgage at 7% would lower your monthly payment to $566. Even though 2% doesn’t seem like a big difference in interest, it adds up to savings of over $120 a month.
The same holds for credit cards. Check what interest rate you’re being charged on your card(s). For example, if you used a calculator on www.cardweb.com, you might see that:
- Let’s say you’re carrying $1,250 in debt on a credit card charging a 12% interest rate. If you stopped using the card today (meaning you didn’t charge anything else), and began paying the debt off at $50/month it would take you 29 months to pay off the debt entirely. After 29 months, in addition to the $1,250 you originally owed you would have also paid $178.89 in interest, for a total of $1,428.89.
- Let’s raise the interest rate on your card to 18%. If you owed the same $1,250 on the card and paid the same $50/month, it would take you 31 months to pay off the card completely and you would have paid an additional $121 in interest, for a total of $298.74 in interest. In total you would have paid the credit card company $1,548.74 for making $1,250 in charges.
Shop around. Before you open an interest-bearing savings account for your savings, or invest your money or take out a loan, ask specifically what interest rate you’ll be earning or paying. Compare interest rates that you’re offered by various banks in the area.
You’ve worked hard for your money and by saving and wisely investing, you can make it work for you. Knowing how much interest you’ll be charged for a loan, or how much interest you can make on an investment, is an important part of managing your money.
Will I get the same interest rate everywhere I go?
No. Banks and financial institutions set their own interest rates. Car dealerships, check cashing stores, department stores, credit unions…the interest rates they offer for purchases vary. It’s important that you compare interest rates when you want to borrow money, earn money by depositing money in a savings account, or when investing money. Call area banks and ask a loan officer what interest rates they charge for their various loans or what interest rate they offer for their savings accounts or for their various investment options. You can use the Internet to do some research as well.
Remember that investing your money is really about you loaning your money to someone else. When you’re comparing different investment options, such as bonds, stocks, mutual funds, and CDs, you’ll want to see how much interest they either guarantee to pay out, for example, on Treasury bills, bonds, or CDs or how much interest they’ve paid out in the past (stocks, mutual funds) that might be an indicator of how much interest they’ll pay out in the future. Remember that investments such as stocks do NOT guarantee how much they will appreciate, or grow in value. You are not guaranteed to make money when you invest in stocks. You can only know how much money investors have made in the past by owning the stock.
Whatever investment you choose, the higher the interest rate offered, the more money you’ll earn on the money you invest. A note of caution: typically the higher the interest rate the greater the risk.
Remember that under law, you cannot be discriminated against when applying for a loan. That means that not only can you not be denied a loan on the basis of race, sex, religion, or national origin, but you also can’t be charged a higher interest rate.
What is a subprime loan?
“Subprime” loans carry a higher than average interest rate and typically charge more fees than traditional loans. You can get a subprime loan when applying, for example, for a home mortgage or a car loan.
If you have a less than perfect credit history (such as paying bills late, filling for bankruptcy or being foreclosed on, carrying a high level of debt or having an unstable employment history) you may be offered a subprime loan. How will you know if it’s a subprime loan? The loan may:
- Carry a higher interest rate than the standard interest rate offered by the bank or financial institution you’re working with
- Have a lower loan limit, meaning that you may not be able to borrow as much money as you would like, or as much money as you could if you had better credit. How much difference does the higher interest rate on a subprime loan make? Consider the example of two brothers – Greg and Ray.
- Greg manages an auto parts store. He has been putting aside 5% of every paycheck into a savings account monthly since he started work and pays his bills on time. When Greg goes to apply for a home loan he qualifies for an $110,000 mortgage at 7%. His monthly mortgage payment will be $732.
- Ray is a claims adjuster. He frequently pays the minimum amount due on his credit cards, periodically forgets to pay his utility bills on time, and has accumulated a high amount of credit card debt. Because he has a poor credit history he qualifies for the same $110,000 mortgage but at 12% interest. That means that Ray will pay $1,132 a month FOR THE SAME MORTGAGE AS GREG. That means that Ray is going to pay about $400 more A MONTH than the same mortgage as Greg simply because he doesn’t qualify for a loan with a lower interest rate.
If you have poor credit, like Ray, you may only qualify for a subprime loan. However, if you have good credit you should not feel pushed into a subprime loan, especially if you suspect it’s simply due to your race or gender. The Equal Credit Opportunity Act (ECOA) prohibits credit discrimination on the basis of sex, race, marital status, religion, national origin, age, or receipt of public assistance. If you are denied a loan, or offered a loan that charges a higher interest rate than is advertised, you have the right to find out why.
To make sure that you’re getting the best, most fair loan you qualify for:
- Shop around. Check for at least three different options when borrowing money. Call banks, credit unions, look online, or talk to a nonprofit counseling agency to make sure you’re getting a loan with the lowest possible interest rate with the loan terms you want.
- Get the entire contract in writing and read it. Know exactly what you’re paying for. Be on the lookout for additional costs such as life insurance, warranties, and ask about anything else that is added into the contract that you’re not sure of.
- Ask questions. If there is anything you don’t understand in the loan documents you’re signing, ask until you are clear on the terms and conditions of your loan.
- Don’t ever feel pressured to sign anything you don’t understand or aren’t comfortable with.
- Don’t agree to anything over the phone or by someone making door-to-door sales calls. Ask them to leave or mail information to your home for you to review instead.
- If you do begin to turn your financial habits around to improve your credit (i.e. paying your bills on time, reducing the number of credit cards you use, etc.) talk to your lender about refinancing your loan. The bank may lower the interest rate on your loan, which will save you money.
How can I make interest rates work for me?
Again, the key is to make sure that you’re earning the most interest possible on money you’re saving and investing and that you’re paying the least interest possible on money you’re borrowing.
Before you deposit your savings in a savings account or before you invest your savings, you’ll want to call around or do some online research to find out which bank or financial institutions will you offer the highest interest rate on savings accounts or on various investment options such as certificates of deposit (CDs), bonds, stocks, or mutual funds.
When you’re borrowing money, do a periodic interest rate check-up. Pick a date, maybe once a year, and take a look at the interest rate you’re paying on your credit cards, loans, or mortgages. You should be able to find the interest rate easily by looking at a recent statement. If you’re not sure, call your bank or credit card company and ask them to look up your account. They should be able to tell you, over the phone, what interest rate you’re being charged. Do a little research to compare it with current rates offered by other cards and banks.
You may be able to save a substantial amount of money by refinancing your home mortgage, auto loan, even your student loan. The general rule of thumb is that you should consider refinancing if your current interest rate (the interest rate you’re paying on a loan) is more than 2 points HIGHER than the current rate being offered. So, for example, if you have a 30-year fixed rate mortgage at 9.75% and the current interest rate is 7% you should think about refinancing. But you’ll also want to consider a few things in addition to the interest rate being offered like application fees and closing costs. You’ll want to add up the total cost of refinancing before signing papers to refinance your loan.
In many cases you can also transfer your credit card balance to another card offering a lower interest rate. Or call your current company and ask if they’ll lower your rate if you’ve been a good customer. Again, before transferring your debt to another credit card, check to find out what fees you’ll be charged for the transfer and check the interest rate you’re being offered on the new card and that it’s not a “teaser” rate – meaning that it will only be good for a short period of time (i.e. 30 or 90 days) and then will increase significantly without you realizing it.