11/18/11

Decisions to save and the interest rate




The interest rate plays a very important role in the economy, and is something that is studied extensively in macroeconomics.  The “interest rate” is usually something we think is associated with credit cards, and mortgage payments.  But you also receive interest in from money kept in your savings account.  This post will discuss the importance of the interest rate from the savings side of things.

It can be useful to think of the interest rate as the opportunity cost of holding money.  Remember that the opportunity cost is the value of the next best alternative.  For example, when you carry money around in your wallet, you aren’t saving it in a savings account.  Your opportunity cost of carrying the money with you is the “cost” of not having it in the bank.  The “cost” of not having it in the bank is equal to the amount of interest you could have earned keeping the money in the bank.  Let’s go through a numerical example:

Time
Carrying Money
Save at 5%
Save at 10%
Now
100
100
100
One Year
100
105
110
Two Years
100
110.25
121

The table above considers four different scenarios, the first where you carry money with you, the second where you earn 5% per year, and the third where you earn 10% per year.  To calculate the opportunity cost of holding money, you simply subtract 100 (your initial money) from the amount you could have earned by saving it.  For example, if you decided to carry money instead of investing it for two years at 5% interest, then it in effect cost you $10.25 to carry that money.  That is the opportunity cost of holding money.

This concept is important, because as interest rates go up, the opportunity cost of holding money also goes up.  You should be very aware of what the interest rates are at your bank for their savings accounts, and for their certificate of deposit (CD) rates.  Note that the growth in savings from now to year one is not the same as the growth from year one to year two.  This occurs because you are no longer earning interest on the initial $100 you put in, but the $105 you now have in the bank.  This is the beauty of compounding interest.

A neat trick for calculating gains from interest is called the “rule of 70”.  If you receive an annual payment, then you can quickly how long it would take to double your money given a certain interest rate.  You simply divide 70 by the interest rate (do not use the decimal), and the answer will be the number of years it will take to double your investment.  For example, if the interest rate is 10%, it would take 7 years for your money to double (70/10).  Common sense would suggest that it would take 10 years to double, but because of compounding interest (interest earned on prior interest) it only takes 7!  If the interest rate is 5% it would take 14 years (70/5), and if the interest rate is 1% it would take 70 years (70/1).  While this method isn’t exact, it gives a good approximation of how long it will take to double your money given an interest rate.

Using the rule of 70 shows how important it is to save money at a high interest rate, even an increase of 1% can take years off the amount of time it will take to double your money.  For this reason you should do your research on savings rates, CD rates, and money market rates before you make a decision.  Being careful with CDs is especially important because it usually ties up your money for a period of time (6 months to 5 years) so be sure not to put too much money into a CD unless you are sure you won’t need it until it expires.

Legal Disclaimer: The article and information provided herein are for informational purposes only and are not intended as a substitute for professional advice.

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1 comments:

Emran Hossen on November 27, 2016 at 3:52 AM said...

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