Alright, gather round. This is going to be important.
You’ve got the basics of a checking account down and are on your way to managing your money properly. If you remember way back at the beginning of this series though, I mentioned there were ways for your money to make you more money, even when you’re not working.
How? One word: interest!
And here’s my simplified definition:
Interest is extra money you have to pay your lender for a loan to make it worth the risk to lend you money.
We’ll talk more about debt later, so for now let’s just stick to a simple example to talk about interest itself and how you can also leverage interest.
How banks make (some of) their money
Let’s say you’re buying a car, but you don’t have enough money to buy one in cash right now.
I can get a loan!
Exactly! If you are considered a low-enough risk by your bank, they agree to give you all the money you need to buy the car right now. The catch is that you have to pay them back all that cash over a long time, usually in years.
The bank would have to wait a long time for me to pay them back then, right?
Exactly. And that waiting around for you to eventually pay them back is risky. That is to say, maybe you really do want to pay back all the money eventually, but then again maybe you found a good deal on a video game console and bought that instead of paying back your loan this month. How does the bank make it worth its while to lend you the money?
Interest. That extra money I have to pay on the loan makes it worth it to the bank to lend me the money in the first place.
Yes! Put simply, the bank charges interest for two reasons:
- To make money. The bank needs to make money too and they do this via interest.
- To compensate them for taking a risk on you. The higher the risk they think you are, the more interest you’re charged.
You can earn interest too
Right, all that sounds good. For the bank. I’m not a bank, though. How does this help me?
Well, remember when I said your checking account was basically a loan to the bank? Like 6 blog posts ago? Here’s a refresher:
The bank needs customers to give it their money so it can lend out that money to make more money back in interest. That makes putting money in the bank effectively a kind of “loan” to the bank. They need your money and want to encourage you to give them that money. Some will even pay interest on these “loans” from you to them, just like you’d pay interest on a car loan!
So if I have a checking account, it’ll make money for me?
Well, sometimes. There are indeed some banks that pay interest on checking accounts, but, for most banks, they don’t. Banks consider checking accounts to be VERY risky loans, since you can basically demand all your money back immediately and the banks MUST pay it all back immediately. You wouldn’t want a car loan whose entire remaining amount could be due basically any day of the week. The bank feels the same way, but will still take the “loan” from you, so long as it’s interest-free.
Got it. So customers “lend” the money in their checking account to the bank, basically for free, but can demand it all back at any time, so the bank doesn’t pay interest.
Exactly. Some banks do pay interest on checking accounts, to be clear, but that’s uncommon.
Okay, so how DO I use my money to make money then, like the bank?
There are a few ways, but the easiest and most readily-available for most people is a “savings account”. Savings accounts are a special type of bank account that will always pay at least a little interest. That may not sound too exciting, but remember: interest is your money making money for you, even while you sleep! So you definitely want to tap into that guaranteed interest the bank is paying.
Sounds like a good place to start at least. More on that next time?
More on that next time.
Thanks for reading.
Common Cents 