Money Tip: Two Kinds of Interest
Albert Einstein once claimed the most powerful force in the universe was compound interest. That's pretty impressive praise from the person whose work helped create nuclear power and atomic bombs. While interest can be powerful, it can also be confusing, because when people talk about it on the news, they mostly talk about it in terms of vague forces and odd numbers. Here's a quick rundown on what interest is, as well as how it affects your life today and in the future.
When someone borrows money, they pay back more than they borrow. Whatever extra money they pay back is called interest, and that's one way that financial institutions and credit card companies make money. That money is basically paying the lender for the risk they take, since there is a chance some of the money wouldn't get paid back. So interest rates can go up or down depending on how likely the money is to be paid back. Credit unions like us work in a lot of the same ways, except that the money they make from interest is shared with credit union members, like you and your family.
So, a high interest rate must be bad, because that means people have to pay more money back, right? Well, it's not really that simple. If it were that easy to understand, then interest rates wouldn't be on the news all the time. There's another kind of interest, which is what you earn on your money. At a credit union, like US Community Credit Union, interest on savings accounts is referred to as "dividend" because it is what you are paid for your share of the cooperative.
When you deposit money into your savings account, it's like we're borrowing money from you. After all, we're holding onto your money, so we pay you dividends. The more money you put into your account, the more we pay you. So, when you save money, you want a higher dividend rate, which allows you to make more money as your savings account balance increases.
That's the confusing part about interest: Some people want a high rate and others want a low rate. Unfortunately, those rates are part of everything around you: If you own your home, you'll want a low interest rate. If you're saving money for college, you'll want a high dividend rate. Just about any business that wants to open new locations or get new equipment is going to need a loan, so they'll want low interest rates. Retired people who have money saved are wise to seek out the highest dividend rates so their retirement savings will last.
Trying to balance all of these people is difficult, which is why the government created a central bank, known as the Federal Reserve (or the Fed) to manage all of this. It can raise or lower the rates for everyone, but it can't do both at the same time. The Fed spends a lot of time figuring out what's best for the country, and it tries to keep its work secret until it's ready to reveal whether it's going to raise or lower rates. It sends out secret shoppers to check the prices on thousands of goods around the country, and uses all that information to figure out what to do.
Hopefully, the next time you're watching the news, it'll be more interesting when they talk about interest rates. It might sound like boring business talk and math, but really it's a report on secret government shopping spies who are working to figure out whether we need businesses to open up new locations or your college fund to grow.