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