Friday, 16 September 2011

Investing 101: Interest

Let's talk about what to do with all that money that you've worked so hard on saving up. In this section titled Investing 101, I'll go over different terms and ideas that every investor should know.* Hopefully the information provided will help give you a general idea of how things work and build a foundation for you to go and further educate yourself. Welcome to class. Today's topic? Interest.

Suppose I ask to borrow $100 from you because I'm short cash to pay rent and I want to get the latest video game (clearly my priorities are in order). You being the good friend that you are, spot me the hundred buckaroos (the actual amount being borrowed is known as the principal). You weren't going to be using it anytime soon. We decide that I'll pay you $100 by end of the month. You loaned $100 and you get $100 back in a year. Did you lose anything?

Well there's the fact that I might not be able to give you back your money (if you were a great friend then you would have known that sometimes it's difficult for me when it comes to paying back loans). This is known as credit risk. The person giving the loan takes the chance that the person getting the loan may not be able pay it back. This is called defaulting on the loan.

You also lose something valuable when it comes to investing: time. As we talked about before, one can put a monetary value on it. In a year's time, you may have been able to use that money to earn you more money. For example maybe you could have did some wheeling and dealing on Craigslist or used it to buy stock. It doesn't really matter, the point it that you had the potential to use that money but that is taken away once you loan me the cash. This is called opportunity cost.

Now that we know that you take on credit risk and there is an opportunity cost to you, would you still loan me the $100 without wanting anything in return? Well maybe you would being that good friend that your are, but what about loaning it to somebody you didn't know? Or the bank (which is what you are essentially doing when you deposit funds into a savings account)? You should be compensated and this is where interest comes in.

The party asking for the loan promises to return the loan with a little extra for letting them borrow the money. This additional amount is a percentage of the loan and this is called the coupon. So if you and I decide that I will borrow $100 with a 3% interest rate, then you would be receiving $103 at the end of the year. In reality, you may be receiving a bit more than that due to compounding effects, but that lesson is for another day. I'm hoping that this basic primer will whet your appetite and motivate you to go and learn more.

-the Paperboy

*I am by no means an expert and have no background whatsoever on the subjects other than what I learn on my own, so do not take the articles in this series as advice. Please remember to do your own research before making any financial decisions.

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