Saving and Investing Basics

We all know that money can be used to buy things, but did you know you could use your money to make money? Saving and investing allows you to build wealth and be prepared for what the future holds.

Compound Interest

Compound interest is a very powerful tool for making your money grow, and involves earning interest on interest you have already received. Let's say you put $1,000 in a savings account that pays 5% interest. At the end of the year, you will have received $50 in interest. Now you have $1,050. ($1,000 x 5% = $50). In the second year, you will earn 5% on $1050, or $52.50. Notice that your money grew faster. You made $50 in the first year, and $52.50 in the second. This is how compounding works. The longer the money stays in the savings account, the faster it will continue to grow, so it is a good idea to start a savings plan as soon as you can.

The Rule of 72

If you had $1,000 lying around, decided to put it into an account and never made another deposit, in a certain amount of time that money would double. That is the cool aspect of compound interest. By using the Rule of 72, we can see how long it will take to double your money. All you have to do is divide 72 by the interest rate the account was paying. Sounds simple, so let's check it out. If you look at an account that earns 4% on your money, you would do the math as follows: 72/4 = 18. It would take you 18 years to double your money.

Risk and Return

There are many ways to save money and build wealth, some of them riskier than others. The more risk, the more potential you have to build wealth. As an example, let us compare two ways to make your money grow: a savings account and a stock. A savings account has very little risk; the money you put into it is insured by the FDIC and you have very little chance of losing your money. On this type of account, you would probably earn about 1.5% interest. Stocks, on the other hand, are very risky. There are many factors that can cause you to lose your money. Because of the high risk, over time you could probably earn an average of between 10% and 11% in interest.

By using the Rule of 72, let us see how long it would take to double $1,000 in a savings account versus investing in a stock. In a savings account you would earn 1.5% interest, so you would do the math as follows: 72/1.5 = 48 years. Investing in a stock, you would earn about 11% interest so, 72/11 = 6.5 years. As you can see, more risk definitely equals more return.

Diversify

Putting all your eggs in one basket is not a good idea. With the high risk of investments, you really do not want to put all your cash into the stock market. Why? Well, the market is volatile and no stock is a sure thing. If you put all your money here and you lose it, you are done. By spreading your money out between both low- and high-risk items, you do not risk losing everything if your investment goes south.

The Taxman and Inflation

There are two more hurdles you must take into consideration: taxes and inflation. You will pay taxes on any interest earnings you make. These taxes are used on both the Federal and State levels to fund the government. Depending on your tax bracket, you could contribute as much as 30% of your earnings to taxes.

Inflation saps the growth of your money because in inflationary periods, the value of money decreases over time. Essentially, inflation occurs when the prices of goods and services rise. These prices rise because of supply and demand within our economy, but this is not an economics lesson, so let's forge ahead. Historically, inflation has grown at a rate of 3% each year. Let's look at an example. Say you bought a soda today for $1. Next year that soda may cost you $1.03. In ten years that soda might cost you $1.30. This will hurt you if you are not getting a greater return on the money you have in the bank. If you were earning 2% interest, your money would be growing at a rate 1% behind inflation. If you saved the dollar for soda and were earning 2% interest on it, next year that dollar would be worth $1.02, in ten years that dollar would be worth $1.20.

When you want your money to grow, you have to be sure that the return, or interest, will be greater than the taxes you will pay and that your interest rate is always higher than the rate of inflation.

Ways to Make Your Money Grow

Savings Accounts: A deposit account that is offered by banks and credit unions. The bank lends your money to people needing loans. In return for using your money for loans, the bank pays you interest, though at a relatively low rate. You do have full access to your money and may withdraw it at any time.

Certificate of Deposit (CD): A special type of deposit account that pays a higher rate of interest than a regular savings account. The reason you are paid a higher amount is that you agree not to access the money for a specific amount of time, such as 3 months, 6 months, 1 year, and so on. If you do withdraw the money, you will pay a penalty.

Money Market Account: These accounts act like a combination of a checking and savings account. You earn interest on these accounts at a higher rate than on a standard savings account. Typically, you must maintain a minimum balance, or pay a fee if you go below it. You can write checks against the funds in this account, but there are limits as to how many.

Bond: When you buy a bond, you are lending money to a corporation or government. In return for loaning them money, you get a specified interest rate which, depending on the type of bond, is paid either at specific periods during the life of the bond or when the bond matures. These are generally long-term investments.

Mutual Funds: A mutual fund is an investment corporation that pools together investors' money to purchase stocks and bonds. The advantage offered by this type of investment is that it is diverse and not dependent on the performance of a single stock or bond. The mutual fund itself does the diversifying for you for much less of an investment than if you were buying each stock individually. A mutual fund is managed full-time by a Fund Manager who decides which stocks to buy and sell every day. Their job is to maximize the return from your investment while maintaining the appropriate risk level.

Stocks: By purchasing shares of a stock, you become part owner of the company. If the company does well over time, the value of the stock should go up. If you sell the stock, you make a profit. Some companies pay their shareholders dividends, which are percentages of their earnings. Stocks are definitely a long-term investment.