Financial Skills

Lesson A: Money Management

Simple Interest

Simple interest is calculated on the original principal only. Accumulated interest from prior periods is not used in calculations for the following periods. Simple interest is normally used for a single period of less than a year, such as 30 or 60 days.

For example, if you had $100 in a savings account that paid 6% simple interest, during the first year you would earn $6 in interest. ($100 x 6% x 1 = $6.00) At the end of two years, you would have earned $12. The account would continue to grow at a rate of $6 per year, despite the accumulated interest. In two years, your savings account would total $112.00.

Compound Interest

Compound interest is calculated each period on the original principal and all interest accumulated during past periods. Although the interest may be stated as a yearly rate, the compounding periods can be yearly, semiannually, quarterly, or even continuously. In contrast, compound interest means more money for the saver

To figure compound interest, add the earned interest to the original dollar amount. Then multiply that number by the interest rate by the number of years to equal the amount earned. With compound interest, $100 in your savings account would grow to $112.36 at the end of two years. Here are the calculations:

Year One: $100 x 6% x 1 = $6
$100 + $6 = $106 year end balance

Year Two: $106 x 6% x 1 = $6.36
Your savings account total at the end of year two would be $112.36
$106 + $6.36 = $112.36

The Rule of 72

Doubling your money is easy to figure with the rule of 72. To determine about how many years it will take to double your money, divide 72 by the interest rate. For example, if you have a 10% interest rate, divide 72 by ten. At that rate, you'll be able to double your investment in 7.2 years.

Saving vs. Investing

Saving is storing money safely, such as in a bank or money market account, for short-term needs such as upcoming expenses or emergencies. Typically, you earn a low, fixed rate of return and can withdraw your money easily.

Investing is taking a risk with a portion of your savings such as by buying stocks or bonds, in hopes of realizing higher long-term returns.

Common Investment Vehicles

Common investment options include bonds, mutual funds, stocks, real estate and retirement plans.

Bonds are basically an "IOU" certifying that you loaned money to a government or corporation and outlining the terms of repayment. Here's how it works: The buyer purchases a bond at a discount. The bond has a fixed interest rate for a fixed period of time. When the time is up, the bond is said to have "matured" and the buyer may redeem the bond for the full face value. Corporate bonds are sold by private companies to raise money. If a company goes bankrupt, bondholders have first claim to the assets, before stockholders. Municipal bonds are issued by any non-federal government. Interest paid on the bonds comes from taxes or from revenues from special projects. Earned interest on municipal bonds is exempt from Federal income tax. The safest investment you can make is U.S. government bonds. Even if the U.S. government were to go bankrupt, it is obligated to repay the bonds.

Mutual Funds are professional managed portfolios made up of stocks, bonds and other investments. Individuals buy shares, and the fund uses the money to purchase stocks, bonds and other investments. Profits are returned to the shareholders on a monthly, quarterly or semiannual basis in the form of dividends. One advantage of mutual funds is that it allows small investors to take advantage of professional account management and diversification normally only available to larger investors. There are a wide variety of mutual funds available.

Stocks represent ownership of a corporation. Stockholders own a share of the company and are entitled to a share of the profits as well as a vote in how the company is run. Company profits may be divided among the shareholders in the form of dividends. Dividends are often paid quarterly. Larger profits can be made through an increase in the value of the stock on the open market. If the stock market goes up, the gain can be considerable. Money is easily accessible on actively traded stocks. If the market goes down, the loss can also be considerable. Selecting and managing stocks often requires study and help. There are a variety of resources available on the Internet, as well as reputable brokerage firms.

Real Estate generally offers the best protection against inflation. Investors can buy a house to live in, and later sell at a profit. Or, they can buy income property, such as an apartment, house or rental unit or commercial property. Or, they can buy land and hold it until it rises in value. The biggest disadvantage of real estate is that it cannot be easily converted to cash. This is a specialized investment that requires study and knowledge.

Retirement Plans

Retirement Plans help individuals put aside money to be used after they retire. Federal income tax is not immediately due on money put into a retirement account, or on the interest it makes. Income tax is paid as the money is withdrawn. Penalty charges apply if the money is withdrawn before retirement age, except under certain circumstances. Since income after retirement is usually lower, the tax rate is often lower. Some types of plans include: Individual Retirement Account (IRA), Roth IRA (also called IRA Plus), 401(k) and Keogh plan.

• IRA - An IRA allows a person to contribute up to $2,000 of earnings per year. Contributions can be made in installments or in a lump sum. IRA contributions can add up fast. Here's an example. If between the ages of 22 and 30 (9 years) you contribute $2000 per year, for a total investment of $18,000, at an interest rate of 9%, and then at age 65, you will have $579,471. Or, if contributions are made for 35 years, between the ages of 31-65, at $2,000 contributed per year, for a total investment of $70,000, then with an interest rate of 9%, you will have $470,249.

• Roth IRA - The $2,000 annual contribution is not tax deductible, but the earnings on the account are tax-free after five years. The funds from the Roth IRA may be withdrawn after age 59, or if the account owner is disabled, or for educational purposes, or for the purchase of a first home.

• 401 (k) - This plan allows a person to contribute to a savings plan from his or her pre-tax earnings, reducing the amount of tax that must be paid. Employers match contributions up to a certain level.

• Keogh plan - This plan allows a self-employed person to set aside up to 15% of his/her income up to $10,000 per year.

Exercise

1. Using the Rule of 72 determine how long it will take to double your money if your interest rate is 5%, 6%, 7%, 8%, and 9%.

2. Use the Internet, or call or visit your local financial institutions to check various savings rates and options. You can search online with skills you've learned already, or try comparative Web sites such as http://www.bankrate.com/.

3. List 6 savings/investment options and determine which best suits your circumstances and risk comfort level.

4. Compare the returns for 5 different mutual funds and a selection of stocks.

5. Look at your own savings and investment plan for your family and see if you're satisfied with it. If not, think about what changes you would like to make.

Quiz

1. Simple interest is calculated each period on the original principal and all interest accumulated during past periods.
True False

2. Mutual Funds are professionally managed portfolios made up of/ stocks, bonds, and other investments.
True False

3. Real estate offers the best protection against inflation.
True False

4. A Keogh plan is a form of retirement plan.
True False

5. A Roth IRA is tax deductible.
True False