Wow! I never thought my first diary would be on this subject; It seems a little off-topic for dkos. I've been working on another diary project to help take our country back. However, there seems to be a need for financial education here, and when I floated the idea a few days ago, there were a couple of yeas, so here goes...
If you are an adult, you bear responsibility for your own financial well-being. You have a tremendous amount of control over it, probably more than you think you do. However, financial savvy does not come out of thin air. Most people are not taught about it in school. The parents do not or cannot teach them either. Also, every business out there wants your money, and many are all too willing to capitalize on your ignorance.
Furthermore, as I hope to show, learning by trial and error can be costly. Once you start down the wrong path, you'll find it hard to turn around and correct it.
Life's a hell of a teacher. It gives you the test first, then the lesson.
Before I begin, let me tell you that I'm not an expert on economics, business, finance, investing, or education. I'm not in the banking industry, either. I'm actually a programmer, but I know a little more than the average person on most of those other subjects. I just happen to have parents who grew up during the Great Depression, are smart, learned to be careful with money, and set a good example for me. Having a good math background doesn't hurt, either.
If all you ever learn about money is what you read here, then you should know about at least these three things:
1. Compound Interest.
Here comes the math. I warned you there would be math. No, I guess I didn't warn you, but it's too late to drop this course now that you're here. As a member of the reality-based community, you need math anyway, since math is reality-based.
You have a pile of money, say $100. You find a place to put the money for a year without adding to it or subtracting from it and it earns interest at a rate of 10% per year. Since 10% of 100 is 10, the interest on $100 will be $10.
Now, if you add that $10 to the account with the $100, you have $110 in the account after one year.
Let's say you keep the money in the account, still earning 10% interest, for another year. This time, it earns 10% of $110, or $11. At the end of the second year, you have $110 + $11 = $121.
Leave it in for a third year, $121 earns $12.10 interest. By now you may be noticing that each year your interest is higher than the year before, even though the rate remains constant. After four years, a $133.10 balance earns $13.31.
Your interest amounts for the first four years are: $10, $11, $12.10, $13.21. Not only are the amounts getting bigger, but the size of the increase is also getting bigger. The increases are $1 ($11-$10) going from year one to year two, $1.10($12.10-$11) going from year two to year three, and $1.21($13.31-$12.10) going from year three to year four.
Is this significant? After 20 years, you'll have $672.75 from that $100. It's like a snowball rolling down a hill. The bigger it gets, the faster it grows.
Now suppose you have a $100 loan, charging 10% interest. Let's assume that you don't make any payments on the loan (for some reason they aren't required yet), and don't borrow any more money. After one year, the interest owed is 10% of $100, or $10. Interest is automatically added to your debt, so you now owe $110.
Another year goes by, you still don't have to start paying back the loan, so your interest is 10% of $110, or $11. Now you owe $121. Hey, do these numbers look familiar? They should. These are the exact same calculations we did for the saving example, where you collect interest. Now you're just on the other side of the deal.
If your lender decides to wait 20 years to collect any money from you, then you'll owe $672.75. Pay up! Do you even remember what you bought with $100 20 years ago? Was it worth $672.75 to wait this long to pay?
This is called compound interest. The interest accrued for one period is added to the balance, so the balance grows, therefore the interest accrued in subsequent periods is higher. Usually, it's done monthly, or sometimes daily, but looking at annual compounding gives you a rough idea how it works. Just remember the snowball, and remember that the snowball can work for you or against you, as we just saw.
2. The Banking Principle.
I call it the Banking Principle. I don't know what it's really called, or if it even has a name. It's just the way I like to think of how banks work.
When I was a kid, I observed my parents collecting interest on their checking account. I knew they put money in, and got more money out. That seemed odd, since I had been under the impression money came from your job. You had to work to get any. How could the bank give out money? So I asked my father how the bank could do that, and he told me that they lend money too. The interest rate of their loans was higher than the interest rate paid to depositors. Fortunately, I had a good grasp of math, so he didn't have to explain any further. I could see right away that the bank could make lots of money borrowing from people like my parents and lending their money to other people at a higher rate. It didn't even matter what the amount of money was. It was the rate that mattered. It's like pouring water into a sink faster than it can drain. Eventually, the sink overflows (the overflow is the profit for the bank).
Let me illustrate this with some actual numbers.
My local credit union offers a checking account paying .40% interest, a money market account with a $25,000 balance pays 1.5%, and a one year CD pays 3%. A car loan costs 5.5%, a mortgage is 6%, credit card is 9.9%. I don't have any of those accounts with them, but I do have a credit card from another bank which charges 15.40% interest.
Suppose you take $25,000 and put it in each of the deposit accounts for a year. You also borrow $25,000 worth of each of the loan types.
Percent means "divided by 100", so you just take the number in front of the percent sign and move the decimal point two places to the left. 40%=.004, so to calculate the interest you would earn from the checking account, multiply 25000 by .004.
Here are all the numbers for one year on $25,000:
Account Type Rate Multiply By Interest
checking 0.40% 0.004 $100
money market 1.50% 0.015 $375
cd 3.00% 0.030 $750
car loan 5.50% 0.055 $1375
mortgage 6.00% 0.060 $1500
credit card 9.90% 0.099 $2475
my credit card 15.40% 0.154 $3850
As you can see, the amounts paid to you for putting your money into a checking, money market, or CD account are pretty small compared to the amounts you must pay to borrow the same amount of money from each type of loan. This is because the rates are higher. It is simple multiplication. Please note that I am again assuming no additions or subractions or payments through the year.
I'll admit this is a rather simplistic model of banking, but you get the idea. Just like any business where you make money by charging more for a product than what it cost you to produce it, banks can actually do this using money itself as the product.
3. Borrowing Money
So is borrowing money good or bad? It depends. There are really only two situations I can think of where borrowing can be positive:
a. Student Loan
b. House
All other debt just drags you down. Sure, you get something sooner than if you saved for it, but things cost more.
What makes student loans and houses different? First, they are expensive. At the time people start college, they haven't got enough money to pay for college. Their parents might, however, if they are lucky. Houses cost so much that saving and paying cash is not possible for most people.
More importantly, these two items give something back to you other than enjoyment. Education can increase your earning potential and houses can appreciate in value. A new car does not make you richer. It makes you poorer because cars only go down in value over time. Buying stuff does not make you richer. Going on vacation does not make you richer, unless it is an educational experience and you use that knowledge to make money later.
Try to avoid borrowing money unless it is for something that will lead to more money. Do not borrow for fun. If you find yourself borrowing for survival, you know you're already in deep trouble.
Extra Credit (pun definitely intended)
Here is some bonus information for anyone who has read this far. People often wonder whether carrying a balance on a credit card will help their credit score. This is part of the larger question of what determines one's credit score.
The first thing I want to point out is that your credit score is only useful if you want more credit. So if you're planning on buying a house or going back to school, you'll want to know what it is. If you are borrowing for something else, see point #3 above, and then, if you still want to know what it is, go ahead and check it.
To make your score better, the best thing you can do is always pay your bills on time. That is the single most important factor in determining your credit score. Anything late or in default will sink your credit very quickly.
If you carry balances on your cards, the effect is computed by dividing the total credit used (over all cards) by the total credit limit (over all cards). Anything over 30% reduces your score. Anything under 30% increases your score. Anything under 15% increases your score a lot. Since 0% is less that 15%, a zero balance on your credit cards increases your score by as much or more than any positive balance.
See here for more detail. Be warned, the information is not presented as clearly as it could be. The line in the table labeled "%Balances Available" should probably have been called something like "%Available Balance USED," since its definition is the one I used above.
In case you were wondering, all of the above information will be on the test. And much more. The test starts now and lasts the rest of your life.