Financial Literacy: A Guide to Your Finances
The Power of Interest
Interest is an important consideration when trying to grow your personal wealth. If you want to borrow money, you’ll of course want the lowest interest rate possible. And, conversely, if you’re putting money into an interest-yielding investment, you’ll want the highest interest rate possible. There are two types of interest: simple and compound.
Simple interest is the amount you can earn on the money you initially invest. As time passes, your investment will grow through interest. The basic formula for calculating simple interest is: principal balance x interest rate. Then you would multiply the product by the amount of years the money will be invested to figure out what the rate of return would be over that time.
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Compound interest is the amount you earn from your original investment plus the interest you’ve earned in addition to the interest you’ve already earned. This is the formula for calculating compound interest: A=P(1+r/n)nt. In this formula, “A” is the amount after compounding interest has been calculated. “P” is the principal amount you’ve invested. The value “r” is the applicable interest rate (in decimal format), “n” is the number of that the interest will compound each year, and “t” is the total number of years.
The more frequently the interest compounds, the more interest you will accrue on your original investment.
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Simple Interest v. Compound Interest
Clearly, we can see that an investment will grow faster via compound interest than simple interest, so compound interest can be your best friend when it comes to investments. However, if you have a loan, it’s in your best interest (no pun intended) if the loan only accrues simple interest rather than compound interest. Fortunately, most car loans and home mortgages accrue simple interest only and do not compound. Some examples of loans that compound are private student loans.
Unless you prefer to store your personal wealth in the form of gold bars buried in your backyard or large bills stuffed in your mattress, you probably have a checking account with your local bank. Checking accounts are a very safe place to deposit your money and are insured by the Federal Deposit Insurance Corporation (or “FDIC”) for up to $250,000 in the event the bank runs into financial difficulty. Also, banks will offer prospective customers various perks to entice you to open an account, such as low interest credit cards and other rewards. Checking accounts can be joint accounts, meaning that more than one person can own and have access to it. For example, many married couples have joint checking accounts.
Unfortunately, checking accounts generally don’t pay high interest rates since they are mainly used for frequent transactions such as paying rent, buying groceries, withdrawing cash, etc. Funds can be paid out from a checking account via various methods, including check, debit card, wire transfer, or other third party methods such as Paypal. Also, nowadays many employers will pay their workers electronically via direct deposit instead of by check, which can be very convenient.
The downside is that most banks will charge fees depending on the type of checking account. For example, many banks require that you maintain a minimum daily balance or else they will charge you a fee at the end of the month. As such, it’s best to shop around and see which banks offers the lowest fees.
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Savings accounts are similar to checking accounts in that they allow you to deposit your money in a bank for safekeeping. Also, just like checking accounts, they are insured by the FDIC for up to $250,000. In return for depositing your money, the bank will pay you interest on your deposit, which is almost always higher than the checking account interest rate. As such, it makes sense for you to shop around for competitive interest rates.
However, unlike a checking account, savings accounts aren’t meant to be used for frequent transactions. In fact, there are federal regulations that say savings accounts can be used for not more than six outgoing transactions in any given month. Many banks will automatically convert your account to a checking account if this limit is exceeded.
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Certificate of Deposit (CDs)
A certificate of deposit (or “CD” to its friends) is a type of financial product sold by various financial institutions such as banks. A CD is similar to a savings account, but the main difference is that the deposited funds cannot be withdrawn for a specific amount of time, which can be a few months or even a few years. If the money is withdrawn early, you could incur penalties. CDs are seen as a very safe and stable financial products since, just like checking and savings accounts, they are insured by the FDIC.
When considering different CDs, it’s important to shop around for favorable interest rates, which aren’t currently very high, but usually higher than the rates offered for savings accounts. Also, longer-term CDs, such as those lasting for multiple years, pay a higher interest rate than short term ones.
In general, insurance is an agreement between a person (or a business) and an insurance company that establishes a policy to cover loss. If the insured experiences a loss or other damage that is covered by the policy, then he/she will receive financial reimbursement in the amount of the loss. The insured will make regular premium payments to the insurance company to ensure the policy remains active. Insurance companies will pool the risk of its customers so that the premium payments are more affordable. There are many types of insurance available, including auto, health, homeowners, life, and umbrella.
In the event the insured causes a car accident, the insurance company will assist in defending the insured and, if found at fault, pay damages to the other party, which can include property damage and bodily injury. There are coverage limits that the insured can choose, which will affect the amount of the premiums. Each state that requires drivers to have auto insurance has a set minimum amount of coverage that all drivers must carry.
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Homeowners insurance is a type of property insurance that covers damage and losses to a person’s home, including personal property in the home. In addition, homeowners insurance also affords liability coverage for accidents occurring in the home and on the home’s property.
Also, when a person buys a home with a mortgage, the lender will require that the borrower secure homeowners insurance as part of the loan. The purpose behind this requirement is clear: the lender is looking to protect its investment. Each homeowners policy has a liability limit and the amount of that limit will affect the monthly premium. Generally, acts of God and certain natural disasters such as earthquakes and floods are not covered by homeowners policies, so it’s always important to thoroughly review a policy to see what’s covered.
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Health insurance is a type of policy that covers expenses associated with an insured’s medical and surgical expenses. Sometimes, the insured will pay these expenses out-of-pocket and then be reimbursed by the insurance company, or, alternatively, the insurance company will make payments to the healthcare provider directly (e.g. doctor, hospital). In some countries, healthcare is provided by the government and considered a basic right, and in other countries (such as the USA) insurance is made available to customers by private companies in exchange for a monthly premium. Sometimes these premiums are paid by the insured’s employer as part of his/her compensation.
A life insurance policy is intended to provide financial security to designated beneficiaries if/when the insured dies. The insured pays a regular premium and, in exchange, the company will pay out a lump sum amount (also known as a “death benefit”) to beneficiaries when the insured dies. There are several types of life insurance policies, including “term life,” “universal life,” and “whole life” policies.
1. Term Life Insurance
Term life insurance affords protection for a set period of time, usually 10 or 20 years. The premium paid by the insured remains the same for the term of coverage. After the term expires, some policies will offer continued coverage, but at a higher premium.
Term life tends to be cheaper than permanent life insurance. Also, term life insurance can be used to pay for lost potential income during the insured’s working years, thus providing a safety net for beneficiaries. And, even though term life can be used to replace lost potential income, the life insurance benefits are paid in a one-time lump sum, rather than at regular intervals.
2. Universal Life Insurance
In general, universal life insurance is a form of permanent life insurance which will cover the insured for his/her lifetime. As opposed to whole life insurance, universal life policies permit the insured to increase or decrease premium payments over the course of the insured’s lifetime. As a result, this type of insurance policy usually requires a higher premium payment.
Universal life insurance can also be used to replace long term income and for other benefits, such as loans, withdrawals, and pension funding. And, in general, universal life insurance can also help with transferring wealth to beneficiaries.
3. Whole Life Insurance
Whole life insurance is a category of permanent life insurance that affords lifetime coverage. As a result, the premiums for whole life coverage tend to be higher, as compared to term life. Premium payments for these policies tend to be fixed and have a cash value that can operate as a savings option which can be tax-deferred as time goes on. Much like universal life insurance, whole life insurance can also help with transferring wealth to beneficiaries.
An umbrella policy is basically additional liability insurance that helps protect the insured from large legal claims and lawsuits. People who purchase this type of policy usually do so to protect large assets. For example, umbrella insurance will provide additional liability coverage in addition to the established limits of the insured’s homeowners and auto insurance policies. Umbrella policies usually cover claims made for personal injuries, property loss, and certain types of lawsuits, such as slander, libel, and false arrest.
When a corporation wants to raise money, it can issue stock which represents a share of ownership in the company. By owning a share of stock, the stockholder owns a percentage of the company and is entitled to a percentage of the company’s profits. As a result, if the value of the company increases, so does the value of the stock.
These are various types of stock, but the most frequently traded on stock exchanges is called “common stock.” This type of stock usually affords the owner one vote for each share owned. Also, owners of common stock may be able to receive “dividend payments,” which are regular distributions of company profits (usually on a quarterly basis).
On the other hand, “preferred stock” usually doesn’t come with voting rights and are not generally traded on a stock exchange. And, if a company chooses to pay out dividends to shareholders, owners of preferred stock will usually have “preference,” will sometimes receive a larger share, and be paid before common stock owners. Also, if the company declares bankruptcy and the assets are to be sold, the preferred stockholders will be paid first.
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Basically, a bond represents a debt obligation. For example, when a company or a government entity wants to raise money through borrowing, they can issue a bond. The money generated for the company or government entity is considered a loan which will be repaid over time with interest. In essence, the bondholders are lenders. Unlike stocks, bonds tend to be less volatile because payments are made at a predictable rate of return, whereas stocks are subject to the uncertainties of the stock market. Also, unlike a stock, ownership of a bond does not represent an ownership share in the company.
A money market security is a type of short-term loan to governments, banks, or large corporations. In general, they are considered safe, liquid investments. However, the returns offered tend to be lower than other investment options. There is no official “money market” exchange, but the best way for investors to purchase them is via a money market mutual fund, which is a type of mutual fund that is managed by professionals. Types of money market securities include treasury bills, certificates of deposit (CDs), and commercial paper.
A 401(k) plan is a type of employer-provided retirement savings plan that allows workers save and invest a portion of their income before taxes. The employer will deduct a set amount from the worker’s paycheck and deposit it into the plan. Taxes are paid when the funds are actually withdrawn from the account. Decades ago, companies would instead offer pensions to their employees (more on that below), but many pensions have been phased out in favor of the 401(k) plan.
One appealing feature of a 401(k) plan is that the worker has control over how his/her money is invested. Plans are usually maintained by an administrator who will keep workers updated about the plan and help facilitate requests. Many plans offer various mutual funds which will include a mix of stocks, bonds, and money market investments. One negative is that when money is invested in a 401(k), it can’t be touched before retirement without penalty. Also, the worker must remain with the company for a set amount of time before his/her rights in the 401(k) fully vest.
An IRA (“individual retirement account”) is a type of retirement account that allows individuals to grow their retirement investments on a tax-free or tax-deferred basis. To clarify, an IRA is not an investment in itself, rather, it’s an investment account that is created at a brokerage firm or other financial institution through which the owner can make investments for retirement. There are three types of IRAs: traditional, Roth, and rollover.
1. Traditional IRA
Traditional IRAs allow the owner to contribute funds on a tax deductible basis and continue to grow those funds tax-deferred until they are withdrawn during retirement. Also, this money may be taxed at a lower rate during retirement since many retirees are in a lower tax bracket at that time.
2. Roth IRA
A Roth IRA is different from a traditional IRA in that the owner contributes money to the account after taxes have been deducted. The funds then grow tax-free and no taxes are owed when the funds are withdrawn during retirement, provided that set conditions are satisfied.
3. Rollover IRA
A rollover IRA is an account that allows the owner to “rollover” (a/k/a transfer) funds from a qualified retirement plan, such as a 401(k) or 403(b).
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Not as common these days, a pension is a retirement plan that a pays out on a monthly basis during retirement. Pensions are mainly offered by government agencies and some large corporations. However, many companies have chosen to offer other retirement options such as 401(k) plans.
Under a pension plan, the employer contributes money to the pension plan on behalf of the worker. After the worker reaches a preset retirement age, those funds are paid out on a monthly basis. The amount of the pension is calculated using a formula that takes into account 1) number of years working for the company, 2) age, and 3) compensation. In general, more years with the company means larger pension payments after retirement. Pensions are regulated by the Department of Labor and are must follow strict rules.
Similar to a 401(k) plan, pensions are also governed by a vesting schedule, which states how much the worker will receive, depending on long they have been with the company. In general, pension benefits are taxable and the worker should decide if taxes should be withheld from the pension payments.
Also known as a credit report, a credit profile is an important factor banks and other institutions take into account when deciding whether to issue a credit to the applicant. Common types of credit include credit cards and loans. Also, landlords will look at a prospective tenant’s credit profile to decide whether to rent to the tenant.
The three credit bureaus in the U.S. are TransUnion, Experian, and Equifax. Congress formalizes the credit reporting system in 1970 when it passed the Fair Credit Reporting Act (or the “FCRA”). By federal law, each person is legally entitled to access copies of his/her credit reports from all three bureaus for free at www.annualcreditreport.com once per year.
If a person’s name is already on a credit-based financial product such as a credit card, utility bill, or loan, that lender may choose to let the credit bureaus know about the account activity. For example, if the borrower is consistently late in paying bills, that could reflect poorly on his/her credit profile.
A person’s credit profile (and therefore their credit score) can be affected by various factors, including, payment history, how credit is used, how far back the credit history goes, and how frequently a person applies for credit. Taking into account these and other factors, the resulting credit score can affect the terms of a loan, such as the interest rate and borrowing limit.
Someone who suspects that they have been the victim of identity theft may want to consider “freezing” or “locking” their credit. These are two different things, so it’s important to understand the implications of each. When a person “freezes” their credit, the credit bureaus will restrict access to their credit profile until it is unfrozen. Freezing will usually cost $10 and the use of a PIN number to unfreeze the profile. On the other hand, while a credit “lock” also restricts access to the credit profile, it can be unlocked at any time.
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A credit card allows a person to make purchases that a bank or financial institution will cover. If the cardholder repays the amount to the credit card company within the so-called “grace period” (which is usually around 30 days), there is no interest charged. If the outstanding balance is not paid off within the grace period, then the cardholder will need to pay interest in addition to the outstanding balance.
1. Unsecured Credit Cards
An unsecured credit card is the most common type of credit card. These cards are not secured by collateral (such as a car or home), which means any money charged is basically an unsecured loan. As such, if the cardholder defaults, the credit card company would need to use methods such as bringing lawsuit or using collection agencies to collect the owed amount. Credit card companies will look at a potential cardholder’s credit profile and credit score to determine a credit limit and interest rate.
2. Secured Credit Cards
A secured credit card is an option for people who have poor credit. This card requires that the cardholder make a cash deposit as security, which helps lower the risk of the credit card company. In general, the deposit is equal to the credit limit. So, if a person deposits $400, then the unsecured credit card has a $400 limit.
If a bill isn’t paid, then the credit company will deduct the amount owed from the deposit. Over time, if the cardholder is responsible and pays their bills in a timely manner, then their credit will improve and they may qualify for an unsecured credit card. Sometimes, secured cards will allow the cardholder to upgrade the account directly to an unsecured card.
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In basic terms, a payday loan is a short-term, high-interest loan, usually for $500 or less, that is supposed to help borrower bridge the gap between paychecks. While they can be appealing, there are some dangers. For example, the lender will usually have access to the borrower’s checking account to directly withdraw the money owed, or the borrower can be required to write a check to the lender for the full balance owed (principal plus interest), which the lender can cash on the day the loan is due. In addition, the interest rates can be extremely high and borrowers can be on the hook for far more than they borrowed in the first place.
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Bankruptcy is a legal process in which a person declares himself or herself unable to pay outstanding debts. A business can also declare bankruptcy, which will usually result in the business closing or continuing to operate with reduced payments to creditors.
Two commonly used forms of bankruptcy are Chapter 7 and Chapter 13. With Chapter 7 bankruptcy, qualifying debt such as credit card bills can be wiped out, and the trustee liquidates some of the property in order to pay back the debt. Some property is exempted under state law. With Chapter 13 bankruptcy, the individual may keep their property, but will pay the creditors for the value of certain (non-exempt) assets, subject to a Chapter 13 bankruptcy payment plan, which usually lasts 3-5 years.
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Debt Negotiation / Settlement
Sometimes borrowers will seek to negotiate and settle and outstanding debt and will hire companies to assist in this process. The overall goal is to get the creditor to settle for a lower amount than what is owed.
However, it’s important to be cautious when engaging a debt settlement company because they can charge substantial fees for the amount of debt forgiven (sometimes 25%!). Also, the IRS classifies forgiven debt as income, which means taxes will likely be owed on the amount of the forgiven debt. Lastly, lenders can report the settlement to the credit bureaus and it may be seen as a negative mark on the borrower’s credit report for up to seven years. Given all these factors, it’s crucial to thoroughly research a debt settlement company before hiring them, because it may be cheaper to simply pay off the debt.