The Financial Student

Explaining Compound Interest

A few weeks ago I mentioned to a friend that she should get a new savings account that pays more interest. She asked me how much more she could be earning. I told her that my bank pays 1.30%. Hers only paid 0.25%! In other words, she would earn 65 dollars every month on her balance of $5000. Not bad…

Except for the fact that I was wrong.

Unfortunately, I was thinking of simple interest. It’s simple because all you do is take the balance (in this case $5000) and multiply it by the interest rate (1.30%). I also thought that my bank paid me 1.30% every month.

Unfortunately, in the banking world things aren’t always as they seem.

Instead of simple interest, banks typically use what’s called compound interest. It’s called this because the money you earn is added back into your account. Basically, compounding is the process of interest earning interest. The interest is typically compounded (added to the account) every month. (This is a good thing when you’re saving money by the way.)

Things get sticky however when advertising gets in the picture. When a bank advertises the interest rate for a savings account, they give you what’s called the APY. This stands for annual percentage yield. This means that you earn the interest rate over the course of the entire year.

So you will in fact earn 1.30% or 65 dollars, but it’s going to take you the whole year (annual=year) to do it. Each month, you’ll earn 1/12 of 1.30%. So instead of earning 65 dollars each month, the bank will pay something like 5 dollars and 42 cents. It’s still free money of course, but it’s not as simple as you’d first believe.

I’ve created this simple table to show you how much you’d have each month.

Things change a bit when you borrow money. Instead of giving you the APY, banks give you the APR or Annual Percentage Rate.

Why do banks use two different terms and calculations? Because they want to make their product look more appealing.

Let’s look at how credit card companies use APR to make you think you’re getting a better deal.

Let’s say you charge $2000 on a credit card that charges a 23% APR. You might think that if you don’t make a single payment all year, that at the end of the year, you would owe $2460. (2000*0.23=460). But compounding interest tells us this isn’t the case.

APR does not take into account compounding. What does this mean? It means that a credit card with an APR of 23% has an APY of 25.58. So from the above example where $2000 was charged, the interest charges would bring the total to $2576.05. That’s an extra $116.05! Plus, remember that the interest is compounding every month.

In the end, it’s up to you to know what you’re getting into. Obviously, the banks don’t make this super easy. But with a little research, you can figure out what’s really going on behind the scenes.

Before Filling Out the FAFSA, Apply for a PIN

On January 1st of every year, the FAFSA (Free Application for Federal Student Aid) goes online. This is a really important form to fill out. With the information you provide, the government (along with universities) decide how much financial assistance you qualify for. But before any of this can happen, you must apply for a PIN. If you can, do this right away. (Seriously, if you have 10 minutes you can do it fight now. Follow along with me)

This personal identification number is really important. It’s the electronic equivalent of your signature. You’ll use this number to sign off on loans and other forms of assistance. The reason to do it before January 1st is because it can take 1-3 days to get the information verified. And the sooner you complete the FAFSA, the more money you’re likely to receive.

Ready? Good. Let’s begin.

First, you need to know your social security number, birth date, address, and email address. Once you know all this, head to http://www.pin.ed.gov.

Once there, click on “Apply Now”

Next, you’ll be presented with some information. None of this is super important, it’s just the general “there are 3 steps, here they are blah blah blah.” Click the picture to enlarge it.

Go ahead and click Next.

Then, you’ll see this:

On this page, you need to enter some information. Remember, no dashes or spaces in between numbers, challenge question is case sensitive, etc. If you do not know your social security number, do not guess. This number identifies you with the United States federal government. You don’t want to accidentally apply for financial aid as someone else.+

After you’ve double checked things and clicked submit, you should see this:

Read the terms and decide if you agree with them. (Hint: If you don’t, you won’t be getting financial aid.)

Select “I agree not to share my PIN”. Now you have 3 ways to receive your PIN. I chose email. That way I get it immediately and there’s a record of it. Having it mailed is also fine, but I didn’t want to wait on the postal service.

Finally, you’ll be presented with this screen:

Go ahead and print this page out or at least write down the number.

Once you do this, you’re done! The PIN you chose or the one given to you will be on its way. Once you have this, you can fill out and submit the FAFSA in January.

But the Credit Card Company Said I Could Just Pay the Minimum!

One of the quickest ways to prevent wealth is to become burdened with credit card debt. The debt often starts out innocently enough but soon grows out of control. Even worse, the debt can years to pay off if only the minimum payment is applied.

Example:

Bob turns 18 and signs up for the 1st credit card he can find. It charges a 21% interest rate. He needs a laptop for school. He finds one he likes, it costs $800. After receiving the bill a few weeks later, he finds that he only has to pay 5% of the amount or $40.00. He continues to do this every month. Guess how long it takes before he actually owns his computer? 5 years and 6 months! Keep in mind that it’s likely he’ll buy a new laptop before 5 years is up, meaning that he’ll still be paying for something he doesn’t even own anymore.

The situation would get even worse if Bob bought more stuff and only paid the minimum. The minimum payment is how credit card companies get rich. In the above example, he gave them $371 more than he had too.

The good news is this isn’t hard to prevent. Just:

• Think first if you really need to purchase the item.
• Next, can you pay off the credit card bill the minute it comes in?
• If the answer is yes, then charge the item.
• If no, start saving.

Follow these rules and you won’t ever have credit card debt.

There. Easy. Done.

Welcome to The Financial Student

Welcome to The Financial Student!

In this blog, I’ll discuss the financial matters that affect teens and young adults the most. From saving for college to understanding how to file taxes for the first time, The Financial Student is here to guide and explain everything.

I hope you’ll stick around to see what I have to offer.

Check back tomorrow for the launch!