Money Matters - The Basics of Managing Your Income
According to the National Endowment for Financial Education, more than 70% of lottery winners go bankrupt within a few years, so whether you make $50,000 a year or $1 million a year, money management is an important part of career management. I realize that not everyone is well versed in managing their money, so I will address a few basic concepts here.
Disclaimer: I am not a finance expert nor an investment advisor. I am just addressing a few topics everyone should be aware of, in simple terms. All the numbers below are for illustrative purposes, and I assume that you are in the United States (or a similarly developed country).
Concept #1: A dollar today is usually worth more than a dollar tomorrow.
This is because of inflation: prices of goods and services tend to increase over time. For example, if you can buy a cup of coffee for $1 today, you may need $1.10 to buy the same cup of coffee next year.
Concept #2: Your income needs to be allocated appropriately to accommodate future expenses.
You need a budget that covers your current expenses and saves for the future. For example, you should set aside money each month to cover your rent, groceries, utilities, and other essential expenses. But you should also save money for emergencies, retirement, and other long-term goals.
If you have a low risk tolerance, the safest and most convenient way to save your money is to put it in different types of FDIC (Federal Deposit Insurance Corporation) insured bank accounts. “The FDIC protects depositors of insured banks located in the United States against the loss of their deposits if an insured bank fails.” They insure up to $250,000 per account. Beware that some banks may offer non FDIC insured accounts (e.g. brokerage accounts, to purchase stocks).
There are five common bank account types where you can allocate your money:
Checking accounts: They are designed for everyday spending. You can use a checking account to write checks, use a debit card, and pay bills online. Most banks do not require a minimum balance in checking accounts, and do not limit how many times you may withdraw money. Typically, banks pay very low interest on checking accounts.
Savings accounts: They are designed for saving money for future expenses. Banks may impose more rules on savings accounts, such as minimum balances or limited number of withdrawals. Violating a rule usually incurs a fee. The benefit of savings accounts is that the bank pays higher interest on the money than a checking account.
High-yield Savings: Very similar to standard savings accounts except that they offer much higher interest rates. You typically find this type of account through online banks. There may be more restrictions on accessing your money, such as no debit card and delays in transfers. If you don’t need to access a physical branch with human services, high-yield savings accounts grow your money at a faster rate. High-yield savings is good for saving for emergencies because you can access it quickly, while accruing higher interest. If you have a checking account at the same online bank, you may use your ATM card to withdraw money from other banks ATMs, and your bank may reimburse you for the ATM fee up to a limit.
Money Market: Offers high interest like a high-yield savings account, but usually includes checking account features such as access to your funds via debit card or checks. However, it typically requires a higher minimum balance than a high-yield savings account. This is not a problem if you are saving for a big purchase like a Peloton or a down payment for a home. If you look hard, you may even find a money market account with no minimum balance requirement, like the Ally Bank Money Market Account at the time of this writing.
CD (Certificate of Deposit): Historically pays a higher interest rate than high-yield savings or money market accounts, but it requires commitment for a time period. In contrast to savings and money market accounts, whose interest rates fluctuate, a CD locks the interest rate in. This is advantageous if you need predictable returns. But your returns may be less than if your money was in, say, a money market account. A CD always has a fixed time length, typically between 3 months to 5 years. If you want to withdraw your money before the time period ends, you pay a penalty fee. CDs are good for people who are fairly sure that they will not need their money during the time period. For example, if you have a vacation in 7 months to pay for, then a CD with a 6 month time period may be appropriate.
Concept #3 - How interest is earned
Interest may be paid daily, monthly, quarterly, or annually, depending on the bank and the account. For the same interest rate, an account that pays more frequently grows your money faster due to compounding (“interest on interest”). You may have seen banks list both the interest rate and the APY (Annual Percentage Yield). The simplest way to explain APY is that it is compound interest. Suppose you have an ultra high-yield account whose interest rate remains constant at 12%:
You deposit $1000 and never add more money.
The bank compounds interest monthly. Then each month you earn 1% interest (12% ÷ 12 = 1%).
After 1 month, the first interest payment is 1% of $1,000 = $10. So, your total balance is now $1,000 + $10 = $1,010.
After 2 months, the first interest payment is 1% of $1,010 = $10.10. So your total balance is now $1,010 + $10.10 = $1020.10
If you keep your money in for 12 months, you will have $1,126.83. You earned a total of $126.83 in interest.
You would see the advertised APY for this as $126.83 / $1,000 = 12.68%, which is higher than the interest rate 12%.
To fully understand how different types of bank accounts work, please do your own research, and decide what works best for you.
If you can tolerate some risk with the potential of higher return and equal measure of loss, you may want to look into mutual funds that invest in other assets like stocks and bonds. Qualified financial advisors who are a good fit for your needs and personality can help you develop a financial plan, choose investments, and make other financial decisions. In the meantime, it would help you to prepare with some knowledge in this area. The Four Pillars of Investing is a classic written by a neurologist Dr. William Bernstein. The market and available products have substantially changed since the time he wrote this book, but it is very educational for novice investors.
