Discussing finances has the potential to be just a teensy bit dry. This sometimes makes people reluctant to think about them. But what do you do if you’re trying to figure out how long it will take you to save up for a new cell phone? Or how much money you need to earn at a summer job to have enough cash for the school year? Simple enough, right? If you need $200 for a new phone, and you make $40 a weekend babysitting, you’ll have the money in five weeks.
Besides, you say, it’s not as though I want to buy anything like a house or a car – or wait, actually, you do sort of want a car, right, and do you really want to live with your parents forever?
Suddenly, things get more interesting.
People save and invest to have enough money at some point in the future to pay for the things they want or need. While you might hear the two terms used interchangeably, saving and investing are distinct concepts that involve different processes. Saving means putting aside for another day some of your money, while investing involves choosing products and strategies to make that money grow.
If you have specific goals that will cost money – such as purchasing a car or a home, or paying for college – accumulating assets and building wealth through saving and investing are essential to achieving those goals.
Saving for the Future
There are many ways to save. One is to open a deposit account in a bank or credit union. Deposit accounts give you easy access to your money, and your account balances are typically insured by the federal government up to a set limit. When you put money into an insured bank or credit union account, you don’t risk losing any of your money – neither the amount you put in, which is your principal, nor the amount you earn in interest.
Another way to save is to purchase U.S. savings bonds. Savings bonds are backed by the federal government so your money is safe. They pay interest until they reach maturity. You can’t cash a savings bond for a year after you purchase it, and you’ll lose three months interest if you cash it in within the first five years. After that, you can cash it any time without penalty and collect the interest that has accrued.
Every savings institution tells you the interest rate it is paying. Interest earnings are added to the principal, or amount on deposit, each time they are paid. This process, called compounding, creates a bigger base on which future earnings can accumulate. For more about compounding, see The Rule of 72.
Learning about Bank Products
Savings institutions offer different types of accounts, which pay different interest rates. In general, the higher the rate paid on an account, the more difficult it is to access to your money. These are the most common types of accounts:
- Basic savings accounts usually pay interest at a lower rate than other bank offerings. You can withdraw or make additional deposits any time you like.
- Money market accounts usually pay a higher rate than basic accounts, but typically limit the number of withdrawals or transfers you can make each month. They may also charge fees or stop paying interest, or both, if your balance falls below a certain minimum.
- Certificates of deposit (CDs) pay the highest rates but require you to leave your money in the account for a specific period of time to earn interest. If you take your money out before the CD matures, or reaches full term, you may forfeit some or all of the interest you expected to earn.
It’s always important to make sure your account is insured by the Federal Deposit Insurance Corporation (FDIC) if it’s at a bank, or the National Credit Union Administration (NCUA) if it’s at a credit union.
If you are willing to take a certain amount of risk with the money you have saved, you can use it to make investments that you expect to be worth more in the future or will pay you regular income over time – or both.
Investments differ from savings accounts because: (1) they are not insured by the federal government and can lose value, and (2) earnings are not guaranteed. If you choose investments carefully and financial markets perform in your favor, your return – or what you get back on the amount you invest – can be higher, sometimes much higher, than you could earn on an insured savings account.
Higher expected returns are accompanied by risk, however. By investing, you take the risk that the investments you choose may not live up to your expectations. You can lose money if you sell your investment for less than you paid for it. In a worst-case scenario, your investment might lose all its value. You can limit your risk, however, by choosing a diversified mix of investments.
While there are many things of value that you might choose to buy because you expect them to provide a profit, the term investment is typically used to describe products that are traded in an organized and regulated marketplace. The best known investments include:
- Stocks, which give you ownership shares in a corporation
- Bonds, which represent a loan you make to an institution in exchange for interest payments plus the repayment of your principal.
- Mutual funds, which pool investors’ money and invest in lots of different stocks, bonds, or other financial instruments
Saving in an insured bank or credit union account is especially appropriate for short-term goals, which you hope to accomplish in a year or two. In this case, you don’t want to risk losing what you have accumulated.
In contrast, investing is usually more appropriate for mid-term and long-term goals because you need the potential for stronger growth that investments can provide to afford the higher priced things you want to pay for. Time helps you to withstand the risks that accompany higher expected returns when investing in stocks, bonds, or mutual funds. It also allows you to recover from potential short-term losses.
Managing Income and Expenses
The first step to saving and investing wisely is getting a handle on your expenses. Unexciting as it sounds, the best way to do so is to write down what you earn, and what you spend. It’s not a bad idea to keep a running log of all income and expenses, even the little ones, for a couple of months. By identifying and eliminating unnecessary extras, you might find that you have more resources than you previously thought.
If you are spending all your income (or worse, spending more than you make by running up debt) and never have money to put away, you’ll need to find ways to reduce your expenses or make additional money. This might require tough choices, such as riding your bike instead of spending all that money on gas for the car.
To free up money for saving and investing, it’s sometimes helpful to divide expenses into those that are essential (needs) and those that are non-essential (wants). For example, basic food and clothing are essential, but you can probably get by without 30 pairs of shoes and dinner out every night.
Paying Off Debt and Getting into the Saving Habit
Using credit can have advantages and disadvantages. If you spend within your means and pay off your balance on time and in full each month, credit cards can serve as a safe, convenient substitute for cash. They can also help you establish and maintain a solid credit history. But if you use them to purchase items you couldn’t otherwise afford – or max out your cards to cover routine monthly expenses – credit cards can quickly compound your debt, because many credit cards charge high interest rates. If you owe money on your credit cards, the best thing you can do is pay off the balance in full as quickly as possible.
Once you have paid off your credit cards (or if you don’t have any credit card debt to start with!), create a budget that includes money to save and invest. That will allow you to chart a course to financial success. To get started, consider adopting this healthy practice: Pay yourself something each month. Aim for a personal savings rate of 10% or more, but if that isn’t a realistic beginning, don’t be discouraged. Any positive savings goal is better than allowing debt to mount.