SAVING AND INVESTMENT BASICS
Creating a personal saving and investing strategy is vital for every financial plan. Putting money aside in a systematic way is the basis for achieving financial goals.
When savings are invested and used, the economy benefits. Individuals, businesses, and governments borrow money from financial institutions. People commonly borrow the savings of others to pay for homes, motor vehicles, and college. When this money is spent, demand for goods and services increases. This results in more jobs and creates more spending by workers.
Businesses borrow funds to operate or expand their operations. Building a new factory, replacing old equipment, or selling a new product are common reasons for business borrowing. These actions create jobs and expand economic activity.
Governments may borrow for highways, schools, or other public services. An economy would be significantly weakened without savings and investments.
Savings and Investment ActivitiesSaving is the storage of money for future use. How much you save, where you put your savings, and what you save for are important decisions. People save different amounts of money for different reasons and in different ways.
Some people save for years and then use those funds for a down payment to buy a home. Saving is also important to have money available for emergencies. Financial planning experts encourage people to deposit 10 percent of their income into a savings account or other investment each month.
After building up some savings, most people want to earn more. Investing means using your savings to earn more money. While a savings plan is a simple type of investing, many other investment choices are available.
Determine Investment GoalsEvery saver and investor has one of two major financial goals: income or growth. People who want income for current living expenses desire current income . People select various types of savings plans and investments to provide current income.
In contrast, long-term growth is the other main investment goal. This goal is for those who desire financial security in the future. Investors who desire long-term growth choose investments that they hope will increase in value over time.
The Growth of SavingsIn addition to putting money aside as savings, you should have those savings working for you. Interest is money you receive for letting others use your money.
If you save $50 a month, in a year, the savings will amount to $600. Suppose you deposit this money in a savings program that earns 6 percent simple interest, paid quarterly. You will earn $9 every three months. You will earn $36 each year. The interest may not be added to your account, but rather is paid directly to you. At the end of 10 years, you will still have $600 in the account but will have earned $360 in interest.
Compound Interest Earning interest on previously earned interest results in faster growth of savings. Compound interest is computed on the amount saved plus the interest previously earned. For example, simple annual interest of 10 percent on $1,000 is $100.
If the interest is compounded, then the interest computed at the end of the next year is based on $1,100 ($1,000 + $100 first-year interest). The 10 percent interest earned in the second year is $110.
Creating a personal saving and investing strategy is vital for every financial plan. Putting money aside in a systematic way is the basis for achieving financial goals.
When savings are invested and used, the economy benefits. Individuals, businesses, and governments borrow money from financial institutions. People commonly borrow the savings of others to pay for homes, motor vehicles, and college. When this money is spent, demand for goods and services increases. This results in more jobs and creates more spending by workers.
Businesses borrow funds to operate or expand their operations. Building a new factory, replacing old equipment, or selling a new product are common reasons for business borrowing. These actions create jobs and expand economic activity.
Governments may borrow for highways, schools, or other public services. An economy would be significantly weakened without savings and investments.
Savings and Investment ActivitiesSaving is the storage of money for future use. How much you save, where you put your savings, and what you save for are important decisions. People save different amounts of money for different reasons and in different ways.
Some people save for years and then use those funds for a down payment to buy a home. Saving is also important to have money available for emergencies. Financial planning experts encourage people to deposit 10 percent of their income into a savings account or other investment each month.
After building up some savings, most people want to earn more. Investing means using your savings to earn more money. While a savings plan is a simple type of investing, many other investment choices are available.
Determine Investment GoalsEvery saver and investor has one of two major financial goals: income or growth. People who want income for current living expenses desire current income . People select various types of savings plans and investments to provide current income.
In contrast, long-term growth is the other main investment goal. This goal is for those who desire financial security in the future. Investors who desire long-term growth choose investments that they hope will increase in value over time.
The Growth of SavingsIn addition to putting money aside as savings, you should have those savings working for you. Interest is money you receive for letting others use your money.
If you save $50 a month, in a year, the savings will amount to $600. Suppose you deposit this money in a savings program that earns 6 percent simple interest, paid quarterly. You will earn $9 every three months. You will earn $36 each year. The interest may not be added to your account, but rather is paid directly to you. At the end of 10 years, you will still have $600 in the account but will have earned $360 in interest.
Compound Interest Earning interest on previously earned interest results in faster growth of savings. Compound interest is computed on the amount saved plus the interest previously earned. For example, simple annual interest of 10 percent on $1,000 is $100.
If the interest is compounded, then the interest computed at the end of the next year is based on $1,100 ($1,000 + $100 first-year interest). The 10 percent interest earned in the second year is $110.
Interest the third year is based on $1,210 ($1,100 + $110 second-year interest) and is $121. When interest is compounded, the amount of interest paid increases each time it is calculated. Without compounding, the interest paid would be only $100 each year.
Interest can be compounded daily, monthly, quarterly, semiannually, or annually. The more frequent the compounding, the greater the growth in your savings.
SAVING AND INVESTMENT CHOICES
Many choices are available for your saving and investing dollars. The choices range from very safe savings accounts to rather risky investments.
Savings PlansBanks, credit unions, and other financial institutions offer a choice of savings plans. Regular savings accounts, certificates of deposit, and money market accounts all provide a safe location for storage of your money.
Savings Account A savings plan with a low balance is a regular savings account. Usually, you may deposit and withdraw money as needed. These accounts pay interest while keeping money safe.
Certificate of Deposit A certificate of deposit allows you to earn a higher interest rate than a regular savings account. This savings instrument usually requires a minimum deposit of $100 to $1,000 or more. You must leave the money on deposit for a specified period, from a few days to several years. Penalties, in addition to loss of interest, may be assessed if the money is withdrawn early.
Money Market Account A money market account pays a variable interest rate based on various government and corporate securities. Interest paid on money market accounts reflects the current rates of interest being paid in the money markets.
In general, money market accounts do not require long-term deposits. They may have a large minimum balance requirement. The earnings on money market accounts are usually higher than regular savings accounts but slightly less than long-term certificates of deposit.
SecuritiesInvestments in securities include stocks, bonds, and mutual funds. Corporations and governments sell these securities to raise money.
Stock Investments When you buy a share of stock, you become part owner of a company. A stock purchase, made directly or indirectly through mutual funds, is a very common way of investing. If a stock increases in value and is then sold for more than its original cost, a capital gain results. When an investment is sold for less than its original cost, a capital loss is the result.
Bond Investments Lending money for use by businesses and governments is another common investment. Bonds represent debt. When you purchase a bond, you are lending funds to a company or government agency to use for their business activities.
Mutual Funds Instead of buying individual stocks and bonds, people can buy shares in a mutual fund managed by an investment company. Money from many investors is used to invest in a variety of securities. Mutual funds allow investors to spread out their risk among many investments.
Alternative InvestmentsOther investment choices include real estate, commodities, and collectibles. These choices often carry greater risk than savings or securities choices. As with all investments, you should carefully review your situation and options before investing in these areas.
Real Estate People invest in real estate for numerous reasons. Many people purchase their own home for the sense of security and stability. Some purchase property for rental income. Others buy vacant property in hopes that its value will increase. Housing, farmland, apartment buildings, and shopping malls are some examples of real estate investments.
Commodities Grain, livestock, precious metals, currency, and financial instruments are all commodities. Investors purchase commodity contracts in anticipation of higher market prices for the commodity in the near future. Commodity investing is considered very risky.
Collectibles Old coins, works of art, antique furniture, and other rare items are often bought with the hopes that their value will increase.
Interest can be compounded daily, monthly, quarterly, semiannually, or annually. The more frequent the compounding, the greater the growth in your savings.
SAVING AND INVESTMENT CHOICES
Many choices are available for your saving and investing dollars. The choices range from very safe savings accounts to rather risky investments.
Savings PlansBanks, credit unions, and other financial institutions offer a choice of savings plans. Regular savings accounts, certificates of deposit, and money market accounts all provide a safe location for storage of your money.
Savings Account A savings plan with a low balance is a regular savings account. Usually, you may deposit and withdraw money as needed. These accounts pay interest while keeping money safe.
Certificate of Deposit A certificate of deposit allows you to earn a higher interest rate than a regular savings account. This savings instrument usually requires a minimum deposit of $100 to $1,000 or more. You must leave the money on deposit for a specified period, from a few days to several years. Penalties, in addition to loss of interest, may be assessed if the money is withdrawn early.
Money Market Account A money market account pays a variable interest rate based on various government and corporate securities. Interest paid on money market accounts reflects the current rates of interest being paid in the money markets.
In general, money market accounts do not require long-term deposits. They may have a large minimum balance requirement. The earnings on money market accounts are usually higher than regular savings accounts but slightly less than long-term certificates of deposit.
SecuritiesInvestments in securities include stocks, bonds, and mutual funds. Corporations and governments sell these securities to raise money.
Stock Investments When you buy a share of stock, you become part owner of a company. A stock purchase, made directly or indirectly through mutual funds, is a very common way of investing. If a stock increases in value and is then sold for more than its original cost, a capital gain results. When an investment is sold for less than its original cost, a capital loss is the result.
Bond Investments Lending money for use by businesses and governments is another common investment. Bonds represent debt. When you purchase a bond, you are lending funds to a company or government agency to use for their business activities.
Mutual Funds Instead of buying individual stocks and bonds, people can buy shares in a mutual fund managed by an investment company. Money from many investors is used to invest in a variety of securities. Mutual funds allow investors to spread out their risk among many investments.
Alternative InvestmentsOther investment choices include real estate, commodities, and collectibles. These choices often carry greater risk than savings or securities choices. As with all investments, you should carefully review your situation and options before investing in these areas.
Real Estate People invest in real estate for numerous reasons. Many people purchase their own home for the sense of security and stability. Some purchase property for rental income. Others buy vacant property in hopes that its value will increase. Housing, farmland, apartment buildings, and shopping malls are some examples of real estate investments.
Commodities Grain, livestock, precious metals, currency, and financial instruments are all commodities. Investors purchase commodity contracts in anticipation of higher market prices for the commodity in the near future. Commodity investing is considered very risky.
Collectibles Old coins, works of art, antique furniture, and other rare items are often bought with the hopes that their value will increase.
EVALUATING SAVINGS AND INVESTMENTSAs you decide which investments are best for you, four main factors should be considered: safety, return, liquidity, and taxes.
Safety and RiskToday, savings accounts at most financial institutions are insured up to $250,000 by the federal government. This insurance is a promise that your money will be available when you need it. Safety is assurance that the money you have invested will be returned to you.
Suppose you lend $100 to someone who promises to pay it back with 10 percent interest at the end of one year. If the loan is paid back, you will receive $110 ($100 + $10 interest). If the borrower has no money at the end of the year, you may get nothing back. You may lose both the $100 you loaned and the $10 interest you should have earned.
Not all investors require the same degree of safety. Someone may have enough money to make 20 different investments. If one of them loses value, the investor still has the other 19. Another person may only have a small amount of money and can make only one investment. One loss would be serious. Most people want to make investments that are relatively safe.
Potential ReturnA good savings plan or investment should earn a reasonable return. The yield is
the percentage of money earned on your savings or investment over a year. Other common names for yield are the rate of return or the annual yield. Figure 19-2 shows the value of an investment of $100 after 20 years at several different yields.
Usually, higher yields and greater risk of loss go together. Investments you make with the federal government are the safest. When you invest money with individuals or businesses, it usually earns higher interest than that paid by the government because there is less safety. For example, the government may pay 3 percent interest on an investment. At the same time, one business may pay 5 percent while a business with even greater risk may have to pay 10 percent.
Most investors will not accept higher risk unless the potential yield is greater. However, a low rate of return on an investment does not guarantee safety. Similarly, high rates of interest do not mean that a loss will surely occur. Higher yields mean that investors believe the situation involves a higher risk. Figure 19-3 shows the risk level for various investments.
The Truth in Savings Act (TISA) requires that financial institutions give consumers information to compare savings accounts. The law defines the annual percentage yield (APY) as the percentage rate equal to the total amount of interest that a $100 deposit would earn based on a 365-day period. APY helps eliminate confusion caused by different interest calculation methods. Some
financial institutions previously used 360-or 366-day years to calculate interest.
LiquiditySometimes cash is needed quickly to pay unexpected bills. Investments that can be turned into money quickly are called liquid. Liquidity is the ease with which an investment can be changed into cash without losing its value.
Suppose you have $5,000 on deposit in a bank. If you need money right away, you usually can go to your bank and withdraw it. On the other hand, suppose you own a piece of land that you bought for $5,000. The land may be a safe investment. However, if you need money immediately, you may find it difficult to sell the land right away. You might even have to sell it for less than $5,000 if you cannot wait for a buyer who is willing to pay your price.
If you have several investments, not all of them need high liquidity. The amount of liquid investments you should have will depend on your expected need for cash in the near future.
TaxesEarnings from most savings and investments are taxed. Taxes reduce your rate of return. For example, if you earn $100 in interest but 20 percent is taken in taxes, you have only earned $80, $100 – ($100 × 0.20). Some investments have tax-exempt earnings, meaning you don't have to pay taxes on that income. These investments are attractive because the tax-free yield may actually be higher than a comparable taxable investment.
Safety and RiskToday, savings accounts at most financial institutions are insured up to $250,000 by the federal government. This insurance is a promise that your money will be available when you need it. Safety is assurance that the money you have invested will be returned to you.
Suppose you lend $100 to someone who promises to pay it back with 10 percent interest at the end of one year. If the loan is paid back, you will receive $110 ($100 + $10 interest). If the borrower has no money at the end of the year, you may get nothing back. You may lose both the $100 you loaned and the $10 interest you should have earned.
Not all investors require the same degree of safety. Someone may have enough money to make 20 different investments. If one of them loses value, the investor still has the other 19. Another person may only have a small amount of money and can make only one investment. One loss would be serious. Most people want to make investments that are relatively safe.
Potential ReturnA good savings plan or investment should earn a reasonable return. The yield is
the percentage of money earned on your savings or investment over a year. Other common names for yield are the rate of return or the annual yield. Figure 19-2 shows the value of an investment of $100 after 20 years at several different yields.
Usually, higher yields and greater risk of loss go together. Investments you make with the federal government are the safest. When you invest money with individuals or businesses, it usually earns higher interest than that paid by the government because there is less safety. For example, the government may pay 3 percent interest on an investment. At the same time, one business may pay 5 percent while a business with even greater risk may have to pay 10 percent.
Most investors will not accept higher risk unless the potential yield is greater. However, a low rate of return on an investment does not guarantee safety. Similarly, high rates of interest do not mean that a loss will surely occur. Higher yields mean that investors believe the situation involves a higher risk. Figure 19-3 shows the risk level for various investments.
The Truth in Savings Act (TISA) requires that financial institutions give consumers information to compare savings accounts. The law defines the annual percentage yield (APY) as the percentage rate equal to the total amount of interest that a $100 deposit would earn based on a 365-day period. APY helps eliminate confusion caused by different interest calculation methods. Some
financial institutions previously used 360-or 366-day years to calculate interest.
LiquiditySometimes cash is needed quickly to pay unexpected bills. Investments that can be turned into money quickly are called liquid. Liquidity is the ease with which an investment can be changed into cash without losing its value.
Suppose you have $5,000 on deposit in a bank. If you need money right away, you usually can go to your bank and withdraw it. On the other hand, suppose you own a piece of land that you bought for $5,000. The land may be a safe investment. However, if you need money immediately, you may find it difficult to sell the land right away. You might even have to sell it for less than $5,000 if you cannot wait for a buyer who is willing to pay your price.
If you have several investments, not all of them need high liquidity. The amount of liquid investments you should have will depend on your expected need for cash in the near future.
TaxesEarnings from most savings and investments are taxed. Taxes reduce your rate of return. For example, if you earn $100 in interest but 20 percent is taken in taxes, you have only earned $80, $100 – ($100 × 0.20). Some investments have tax-exempt earnings, meaning you don't have to pay taxes on that income. These investments are attractive because the tax-free yield may actually be higher than a comparable taxable investment.