The first and totally obvious way to save up your money is to put it in the bank. Duh. You know that. But you may not know exactly how banks work, the various accounts they offer, and why it’s important to shop around for your banking needs.
Banks and savings and loans are good at coming up with fancy names for their accounts; names like “Advantage Plus Mega-Money Super Savings Certificate Account.” But most of their accounts fit into one of four basic categories:
1. Basic savings accounts (sometimes called passbook accounts) have little or no minimum balance and pay minimum interest. Advantages: You can withdraw your money whenever you want (no minimum deposit period), and you earn more interest than if you hid the money in that secret place near your bed (shh!). Disadvantage: You don’t earn much interest.
2. Basic checking accounts don’t pay interest, but they don’t cost you anything as long as you keep a minimum balance, typically $500 to $800. If your balance drops below the minimum, the bank will charge you a monthly fee of $5 to $10. Some banks also charge you a few cents per check, or tack on a fee each time you use an ATM.
3. Money market checking and savings accounts pay better interest than basic savings accounts, with the rate rising according to the amount of the balance. They also have higher minimum balances, usually $1,000 or more.
4. Certificates of deposit (CDs) are guarantees that you will let the bank keep a certain amount of money (generally $1,000 or more) for a certain period (typically, one month to 10 years) in exchange for higher interest. If you need your money before the CD matures, you will pay a stiff penalty. Obviously, the more money you give them and the longer they keep it, the more interest they’ll guarantee. Some banks offer $500 CDs, which makes them a good investment possibility for lots of teenagers.
Juggling Interest
Before you go shopping for a bank investment, you’ll need to know how banks figure interest. There are two kinds: the kind you pay, and the kind you receive. Here’s how it works when you’re on the receiving end.
Let’s say that while walking out of a store, you hold the door for a man who’s entering. He’s amazed at your politeness and hands you $10,000 as a gesture of his thanks. When the crowd revives you from fainting, you remember the $10,000 in your pocket and race to the bank. You deposit the money into an account at a 6% annual percentage rate (APR), compounded monthly. The “6%” part sounds good; the “compounded” part sounds like something for warts. But you make your deposit and go off to tell your friends what happened. The bank puts your money into a little envelope with your name on it and hides it in their vault.
On the first day of the next month, a little man named Harold takes his calculator into the vault to count the money in your envelope: $10,000 (phew!)— which he multiplies by 1/2 of 1% (.005). Your question at this point should be, “Why the heck did Harold pick that number?”
It’s /2 of 6%—one month’s worth of your interest rate. When he multiplies your $10,000 by .005, his calculator will show that the bank owes you $50 in interest for the first month. Then he takes $50 out of a little green money bag he carries and places it in your envelope.
The next month Harold is at it again. He counts the money in your envelope—$10,050, multiplies it by .005, then puts $50.25 into your envelope. Harold does this every month for the year. “Compounded monthly” means Harold takes his calculator into the vault once a month. (Actually, one time he was sick so Hector did it.)
At the end of the year, you decide to withdraw your money. Out of the vault comes your envelope: your original $10,000 plus $616.78 in interest. Wait a minute: 6% of $10,000 is $600—you were overpaid $16.78. Not really. The extra amount was the interest you received on the interest. That’s what’s called compounded interest.
In money talk, your principal of $10,000 yielded 6.17% interest. Yield is a useful word that money people borrowed from farmers. It simply refers to the produce you harvest after planting something. In this case, you planted ten grand in the bank, and a year later your money crop produced 6.17% more than you started with.
Let’s say you decide to put your money in an account paying the same 6% interest, but this time it’s compounded yearly. Twelve months after you deposit the money, Harold takes his calculator into the vault to figure your interest: $10,000 x .06 (12 months’ worth of interest) = $600. Your yield on this account: 6%. This is not only a worse deal for you, but really boring for Harold.
The way to compare interest accounts is by their yields—what you get out of them. As you can see, the shorter the compounding period, the more money you make in interest.
Before we go on, I feel obligated to tell you the truth: Harold doesn’t go into the vault to count your money. Two reasons. First, there’s no one named Harold at your bank—several years ago he was replaced by a computer (I know . . . it’s sad) that automatically calculates your interest at each compounding.
Second, your money isn’t in the vault. The bank loaned it to a woman named Rita who is planning to open the Reptile Emporium down the street (really). Rita is paying the bank 10% interest for the $10,000. After paying your interest, the bank still makes 4% on the deal.
Which brings up the other type of interest: the kind you pay. With a loan, the interest is the fee you pay for the privilege of using the lender’s money. Let’s say the reptile lady’s loan must be paid back all at once at the end of a year. At that time, she gives the bank the principal (the original $10,000) plus 10%, or $1,000 in simple interest. In other words, the interest is calculated once— there’s no compounding as in a savings account. Most lenders charge simple interest. However, there are certain exceptions, and they can get nasty.
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