Finance: Interest, Stocks, and Bonds

WE’VE ALL HEARD THE SAYINGS: “Time is money” and “Put your money where your mouth is.” Despite its reputation as being “the root of all evil,” money is, most basically, anything that is used as a means of payment. Today we use paper, coins, and plastic cards; in the past, people used rocks, tobacco leaves, cigarettes, and gold and silver. Money buys us everything from food to fun, and it’s important to think about money now because pretty soon you’ll be in charge of your own money, and the more you understand about it, the more you will be able to make good use of it. Part of learning about money includes knowing where to put your savings, which is the money you keep instead of spending. The value of your savings increases differently, depending on what you do with it.

INTEREST

When you put money in a bank account, you are actually lending your money to the bank. For the privilege of doing this, the bank pays you a tiny bit each year to “rent” your money. This is called interest. You can take your money out of the bank if you need to, but while it’s in there, the bank pays you interest—usually a set percent of every dollar that you keep in your account, called an interest rate. So if the annual interest rate is 5% and you put $100 in your bank account, at the end of one year you’ll have $105.

COMPOUNDING

Thanks to something called compounding, your money can turn into even more money. If you keep that $105 in the bank for another year, now you’re earning 5% interest on $105. So in other words, after two years, the $100 you started with will turn into $110.25. And all you had to do was not spend it. If you saved that $100 for twenty years, with the interest compounding every year you’d end up with $265.33. Without compounding interest, that $100 would only turn into $200 after twenty years.

Compounding interest is why saving even little bits of money can add up to much more later. However, compounding works against you when you are the one borrowing the money—which is what you are doing when you use a credit card. (It might feel like free money, but it’s not!) When you buy things with a credit card, you’re the one borrowing money, so you’re the one being charged interest—interest that compounds. So if you spend money using a credit card and you don’t pay off your debt every month when the bill comes due, the $100 you spent turns out to cost you much more.

INVESTING: STOCKS, BONDS, AND MUTUAL FUNDS

Putting your money in a savings account is just one way to invest it, or make your money earn money. There are other ways to invest money, but they are riskier, which means while you might earn more, you can also lose some (or all) of your money. Dealing with money means figuring out how much risk you want to take for different kinds of possible rewards.

Stocks

Stock is ownership of a company. When you buy stock (one piece of which is called a share) in a company, that makes you a stockholder (also called a shareholder), and the more stock you own, the bigger your stake in the company. Owning stock means that you own a small piece of the company—so when a company does well and makes money, you make money too. And if it does badly, well, you can lose money instead.

The price of stock can vary from pennies to thousands of dollars, depending on the company. You get to decide when to buy a stock and when to sell a stock. You do this through a stock broker or directly through the company. The idea is to buy low and sell high to make a profit: buying shares of a stock when it’s priced low and then selling that stock at a higher price is one way you make money on your investment with stocks. Stocks are bought and sold—traded—in stock markets, like the New York Stock Exchange, American Stock Exchange, or NASDAQ. You can follow the progress of your stock in the newspaper, on television, or on the Internet.

The other way to make money with stocks is when companies pay out dividends—money paid to all the stockholders every year, the amount of which varies depending on how much a company earns.

Bonds

A bond is basically an “IOU.” When you buy a bond, you are lending your money to a company or government, which they will pay you back later. Bonds give you an interest rate that is generally higher than what you’re going to get in a savings account. The interest is worked into the bond price, and you get both the interest and your money back on the “maturity date.”

Mutual Funds

Mutual funds are another way to invest your money. With mutual funds, a money manager—a person whose job it is to know about investments—decides what stocks and bonds to buy and sell. When you buy into a mutual fund, you buy shares in the fund the same way you buy a share of a single company, but instead you’re putting your money into a big collection (a “fund”) that the money manager uses to buy and sell investments to make money for you. Of course, she keeps a little piece for herself in the end.

Mutual funds are one way to balance out risk, as they involve diversification. When you diversify your investments, you make an effort to not put all your money in one risky thing, or all your money in one safe thing. Instead, you put a little into something more risky, a little into something safe, and a little into something in between.