Life Lessons 101

Everything you needed to know, but was never taught in school.

How does Interest Rates Work?

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Albert Einstein once supposedly said that (compounding) interest is the 8th wonder of the world. Whether that wonder is working for you, or against you, will make it your friend or enemy.

The interest rate, sometimes just called interest, is a percentage of a whole that is paid by one party, for allowing another party to use it.

Interest working for you

Consider a savings account. When you put your money in the bank to “save it”, the bank is going to not just lock it up in a vault. They put that money to work. Because you let them use that money, they pay your a portion of what you put in back extra.

For simple numbers, let’s say that amount was 5%, and you put in $100. At the end of a time period, like a quarter, you’d have that $100, plus an additional 5%, or $5, or a total of $105. At the end of the next quarter, you’d have another 5%, but instead of it being on $100, it’s on $105. That means you’d get an extra $5.25. Now your total is $110.25.

At the end of every period your bank account increases. At the end of four quarters, one year, you’d have $121.55. That is assuming you don’t add any extra money (deposit), or take out (withdraw) from the account during that year.

Your money is literally making money.

Interest working against you

Now why does the bank give you money for putting it in a savings account? Well, that’s because of how it uses it. It will take your money, and the money of other people, and loan it out. So let’s say you wanted to buy a car. They go to the bank, and get a loan for $30,000 and the bank is going to charge you interest to use their money.

For simplicity sake, let’s say it’s 10%. If you doesn’t pay off the loan, the loan amount will be $33,000 at the end of the year. Now, each month the bank will want you to pay down that loan, so you’ll pay a little bit in interest and a little bit in the principle – the amount that they borrowed.

The amount you pay will depend upon how long the loan is for and how much they actually borrowed. In a normal loan situation, you will always pay the interest plus some principle for a given year/quarter/month/etc.

Car loans tend to be for between four and six years now a days, while a home mortgage will be for between ten and forty years. Most of the time it is fifteen or thirty.

Why different interest rates?

The rate that the bank gives you on an account will typically be the same as they give anyone else. Sometimes they will give higher rates to people to put a lot of money in the bank (the banks rewarding them for putting extra money into them so they can make money off of it), but generally you have to have a very large deposit amount to make that higher interest rate ($50,000 to $100,000 or more).

You will also notice that you pay a higher interest rate to borrow money than when you put it in the bank – why is that? Well, the bank has certain overhead cost they have to pay. Everything from the teller who takes your money, to the loan officer who gives you the money you are borrowing, to the buildings that they are in, etc. There are a lot of people and items that have to be paid.

Additionally, the bank knows that some people, despite their best intentions (or not) will not pay back all of the money lent to them, and the bank could lose money in the deal. They have to make sure they cover those potential losses.

How to get a better interest rate when you borrow

The interest you pay on a loan however will vary greatly and are based on a couple of factors.

First is your credit worthiness. Your FICO score will tell a lender how much of a risk you are. i.e. does the bank think you can pay the loan back. A low score is a low confidence, and the lender (bank) will charge you a higher interest rate to cover cases where you might skip town without paying.

Second is what is the loan for. House mortgages tend to be cheaper than most other loans because houses typically go up in value over time, you can’t pick up a house and skip town, and if you don’t pay your mortgage loan, the bank can repossess your house, essentially kicking you out.

A secured loan is one where you are buying something the bank can take back – like a car, boat, etc. Generally the bank can take it back, but they depreciate in value over time, especially right away. So if you don’t pay the loan back, the bank takes the car back (repo man), but the car you bought for $30,000 might only be worth $20,000, so they charge you a higher rate in case they have to take the car back, to reduce the risk of loss.

An unsecured loan, like a credit card, has the highest interest rates. That’s because it is often used to buy things that you cannot return, or the bank cannot take possession of. Think of paying for a dinner, or a vacation on a credit card. The bank can’t take those items back, so to reduce their risk of loss, they charge the highest interest rate for these items.

Current Interest Rates

Now I used 5% interest for a savings rate and 10% for buying a car – however, that isn’t always the case. In fact, now a days, if you have good credit, you’ll see rates much lower than that. Why?

Well, banks loan each other money? If they can get money from another bank cheaper than you, they will. So, your money doesn’t have as much value to them. This means borrowing money is cheaper too…but if you’re trying to save, good luck.

If the over night lending rates for banks were to go up higher, that would make savings accounts pay more, but it would also cost more to buy a car, house etc. Due to a variety of complex economic reasons, we’ve had really cheap interest for nearly two decades… it’s like our economy is hooked on it, and I don’t see us breaking that fix any time soon.

Opening a Bank Account

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So you’ve got that first paycheck. Many jobs now prefer, or even require, you to have direct deposit for your paycheck. You’ll need to open a bank account to deposit your paycheck. But even if your job doesn’t require it, you still might want one. Here’s a couple of reason’s why real quick.

  • Going to a check cashing store will cost you – 3-5% of your check will go right to them. Money that should go in your pocket.
  • A bank account is a good place to put money “out of sight” so you’re not tempted to spend it, and thus have it if a need arises.
  • Getting access means having access to ATMs and Tellers, so you can get cash in case some place doesn’t take credit cards, or their credit machine is down. (Went into one place, and a person had knocked over a telephone pole – no credit card processing for two days for them until it was fixed. Cash let me buy things right then.)
  • Most banks will perform notary services for free for their customers.

Not all banks or bank accounts are equal. There are several things you need to consider when opening a bank account, and the first is actually the bank itself.

First you need to consider the location of the bank branches. How many do they have? Are they near places you go? What are their hours? 

Most things can be done on-line, and that’s great, but having a bank where you can simply walk in is a huge deal. When we moved, we initially weren’t going to change banks because our old bank didn’t have any offices in our state. But boy did we change our tune fast when we needed to talk to someone.

Once you’ve ruled out the banks that don’t work for you, there should still be several left to choose from. Now you’ll want to decide what kind of account do you want. Do you want just a checking account or do you want a savings account as well?

All banks will have both types of accounts, but there are several things that will be different at each bank. Generally speaking, a checking account won’t give you any interest on your money – however, savings accounts don’t hardly any more either.

I usually recommend going with a checking account because of a couple of simple reasons. First, some places require a check, at least initially to set up accounts such as utilities, first month rent, etc (unless you want to pay an additional fee for using a credit card – no thank you), thus it’s nice to have a checking account. Also, you will probably need a canceled check to set up direct deposit at your work.

The next thing to consider is if there is a minimum balance. If the bank requires a minimum balance, if the amount of money in your account dips below this amount you will get charged a fee. Make sure you pick an account that you know you can keep the minimum balance or that doesn’t have a minimum balance. Most banks have a “no-frills” account which only requires $100 to $500 – also check to see if the minimum amount is a daily minimum balance, or and average. The daily balance means if on any one day you drop below the amount you will be charged a fee. The average means you can go below for a few days with out penalty, but you overall want to stay above.

Some bank accounts require an initial deposit, a certain amount of money be placed into the account to open it. Usually this is around $100, but could be more. Fancier accounts with additional features may require more. The most I’ve personally seen at a standard retail bank is $10,000 – but that is rare.

Do you want a debit card or ATM card? Not all accounts include a debit card (checking) or ATM (savings) or may charge a fee to have one or a fee if you use your debit card more than a designated amount of times.

Do you want access to an ATM? Some accounts charge a fee for this convenience or a fee if you use the ATM machines more than a designated time each month. Some banks only have ATM machines available at their bank, while others have ATM machines at their banks and also in other locations. Knowing which is which is important, as you will probably not be charged for using the ATM that belongs to your bank, but if you use one from a 3rd party service, you may be charged a fee by them and/or your bank.

Some accounts have a service charge every month. Many times there is a way to waive this service charge by doing something – keeping a certain amount of money in the account, have multiple accounts at the same bank, having direct deposit, etc. Find out if there is a way you can waive it that works for you. Not every checking account at every bank has a service charge, so look into that too.

Note: Direct deposit is usually the easiest way to avoid a service charge – so if your work offers it, make sure you set it up.

There may also be a limit to the number of deposits or withdrawals per month. If you may need to do either of these, be sure to check and make sure there is no limit before incurring fees.

Most checking accounts will not give you interest and if they do, they usually have many requirements that you must maintain. So if you want an account that will give you interest, you may want to consider opening a savings account or, more likely, a money-market account. Ask your bank about them. In the “old days” savings accounts would give you 3-5% interest on the money in the account, you’d literally earn money on your existing money. Today, a good account will give you 0.1% – which is only slightly better than nothing.

Once again, make sure you check about service charges, minimum balances and fees. Interest rates will vary based upon what bank and what type of savings account you choose. Be sure to look at interest rates and how often do you get paid the interest (monthly or quarterly).

Many people select a bank account based upon recommendations, or the one that is closest to their house/work or simply chose the one that their parents go to without looking at the account details. What works for one person may not be the best account for you. So go to several banks, ask questions about their accounts, get information to take home with you about the accounts and pick the best account for you.