WHAT TO DO WITH ALL THAT MONEY
Posters Encouraging U.S. Citizens to Buy Savings
Bonds: 1945 and 1975
Unit
Overview
Now
that you know what money is, what can you do with it? In reality, people have two options when it
comes to money. They can spend it, or
they can save it. By saving it,
individuals make funds available for others to borrow it. Companies, for example, can use these loans
to expand production, while savers can receive profits through interest and
dividends. This exchange makes economic
growth possible, but, as with all decisions, it comes with trade-offs. Let's see how it all works.
How an
Economist Defines Savings
Economists
define saving as the absence of spending.
In other words, if one is not spending, he or she is saving. The money that accumulates from this lack of
spending is called savings, and it is
essential for economic growth in a market economy. For businesses to supply the goods and
services that people need and want, they must have, along with the other
factors of production, capital. This
includes machinery, equipment, tools and money.
When people deposit money in savings accounts, banks are able to make
loans to businesses. Then, entrepreneurs
have the funds that they need to create new businesses and to update old
ones. Firms also have the financial
means to develop advanced technology, to purchase new equipment and to create
more jobs. For a saver, this becomes an investment, or the use of assets to
earn profits. The profit that the saver
makes above and beyond the initial investment is called a return. All investments come
with a certain amount of risk. An economist
defines risk as the chance that the
actual return will differ from the expected return.
Go to Questions 1 through 3.
The
Financial System
If
investments are going to take place, an economy must have a financial system that permits savers to
transfer money to borrowers. People can
house their savings in a number of locations.
Some may choose to open traditional savings accounts; others may
purchase certificates of deposit or bonds.
In each of these instances, the saver receives a document, such as a
passbook, certificate or computer printout, to confirm that the transaction has
taken place. In the event that the
borrower does not pay back the loan, these records provide legal proof that an
individual, business, or government has borrowed a specific amount of money
that must be repaid.
Although
savers and borrowers sometimes interact directly, they often connect through
financial institutions referred to as intermediaries. Financial intermediaries help direct funds
from savers to borrowers. The table below offers several examples:
|
Financial
Intermediaries |
|
|
Banks,
Savings and Loan Associations and Credit Unions |
These institutions receive deposits from savers. Then, they lend some of these funds to individuals
and businesses. |
|
Finance
companies |
Finance companies make loans to small businesses and
individuals, including clients who have a history of not repaying loans. To cover any losses that may result,
finance companies charge borrowers higher interest rates. |
|
Mutual
funds |
Mutual funds combine the savings of many clients and
invest their money in a variety of bonds, stocks and business ventures. This decreases the risk for savers because
they are not investing in just one company. |
|
Life
insurance companies |
Life insurance companies sell policies that provide financial
protection for families when policyholders die. They lend part of the payments, or premiums, that they collect for this
service to borrowers. |
|
Pension
funds |
Many retirees receive payments called pensions after they work a certain number of years, reach a
certain age or are injured on the job.
Employers often withhold a percentage of workers' salaries for this
purpose and sometimes contribute to these funds on behalf of their employees. Pension fund managers make some of this
money available to borrowers. |
Although
it may seem that savers and borrowers could simplify the process by dealing
with each other directly, there are advantages to working through
intermediaries. Intermediaries help savers to decrease risk by putting their
money to work in a variety of ways. This
strategy of spreading out investments is known as diversification. It reduces the possibility of losing everything if
a single investment fails. On another
front, most savers and borrowers do not have the time or the resources to
research investment opportunities on their own. Because intermediaries collect
and monitor financial data, they are valuable sources of information. The law requires intermediaries to publish
this material in an annual report called a prospectus. Intermediaries also provide savers with liquidity, or the ability to convert
their investment to cash. Let's say that
you decide to invest in a mutual fund.
After keeping the investment for three years, you want to sell it so you
can use the money to buy a car. You can
easily do that. However, suppose you had
purchased several collectable sports cards instead. This would be more difficult to convert to
cash because you would have to find another investor who would buy the cards.
Go to Questions 4 through 7.
Saving
Accounts
Banks
offer a variety of options for savers. Traditional savings accounts are the most
common and are easily opened in person or online. They are especially useful for customers who
tend to make frequent withdrawals.
Because there is no penalty for taking money out of the account, they
are excellent places to store money for emergency purposes. Savings accounts are safe even if the bank
fails because they are insured by the Federal
Deposit Insurance Corporation (FDIC).
However, they only pay a small amount of interest at an annual
rate.
Federal Deposit Insurance
Corporation: Arlington, Virginia
Money market savings accounts pose another
alternative for savers. Because they are
also federally insured, this option qualifies as low risk and pays higher
interest rates in comparison to traditional savings accounts. However, interest rates for this type of
savings program are not fixed but may move up or down depending on economic conditions. They generally require a minimum balance, or a specific amount of money maintained in the
account at all times. The financial
institution also limits the number of withdrawals that a saver can make. Certificates
of deposit, commonly known as CDs, also pay higher interest rates and are
federally insured. Unlike money market
savings accounts, they offer a guaranteed interest rate for a certain number of
years. During that time, the saver may
not withdraw funds from the account without paying a penalty. In other words, the saver gives up immediate
liquidity for a higher return. Money
market accounts and certificates of deposit work well for savers who are
storing money for the long term. The
video listed below explains several things to consider when opening a savings
account.
Choosing a Savings Account
Go to Questions 8 through 10.
Bonds
Sometimes
corporations and governments need to borrow money to finance major projects for
long periods of time. For this reason,
they often issue bonds. A bond represents a loan that a government or
company must repay to its investors.
Bonds usually pay investors stated amounts of interest at regular intervals
for the duration of the loan. Bonds have
three basic features: coupon rate,
maturity and par value. The coupon rate refers to the amount of
interest that the issuer of the bond agrees to pay the lender. The time when the repayment of the loan
itself is due is known as the bond's maturity. The par
value is the amount borrowed, or the principal,
that must be repaid to the lender upon maturity. For example, a corporation sells a $2,000 par
value bond for twenty years at 5% interest paid twice a year. The bond's holder receives $50.00 twice a year
(.05 times 2,000 divided by 2). After
twenty years, the company pays off the debt by giving the holder of the bond the
initial investment of $2,000. The video
listed below explains more about how bonds work.
Bonds
Although
this may appear to be a good way to profit from saved money, not all
corporations and governments are equal in credit-worthiness and financial
health. Unlike savings accounts, bonds
are not insured, and there are no guarantees that the borrower will still be in
existence when the bond matures. How do
investors know which bonds are "good" and which ones are "not so good"? Fortunately, investors can rely on the
research and analysis of two major companies.
Standard & Poor's and Moody's rate bonds on several
factors. They consider the issuer's past
credit history, its ability to cover the interest payments and the likelihood
that it can repay the principal. Bond
ratings, listed in the graphic below, range from AAA (Aaa on the Moody's scale)
to D. Those listed as BB and Ba or lower
are generally the riskiest types of bonds.
At this end of the scale, there is valid information to show that the
interest and/or principal is less likely to be repaid when compared to those
bonds at the top of the scale. Nonetheless,
many bonds are considered reasonably safe investments.
|
Bond Classifications |
|||
|
Standard & Poor's |
Moody's |
||
|
AAA |
Highest Grade |
Aaa |
Best Quality |
|
AA |
High Grade |
Aa |
High Quality |
|
A |
Upper Medium Grade |
A |
Upper Medium Grade |
|
BBB |
Medium Grade |
Baa |
Medium Grade |
|
BB |
Lower Medium Grade |
Ba |
Speculative Elements |
|
B |
Speculative |
B |
Generally Not Desirable |
|
CCC |
Vulnerable to Default |
Caa |
Poor, Possibly in Default |
|
CC |
Other Debt Rated CCC |
Ca |
Often in default |
|
C |
Other Debt Rated CC |
C |
Bonds Not Paying Income (Interest) |
|
D |
Bond in Default |
D |
Interest and Principal Payments in
Default |
Investors
can choose from several different types of bonds, such as the ones listed
below. However, they must keep in mind
that rewards involve trade-offs. As the
potential for higher returns increases, the amount of risk also increases.
Ø Savings Bonds:
Savings bonds are issued by the federal government and have virtually no
risk of default, or failure to repay
the debt. They come in small
denominations ranging from $100 to $10,000.
The money raised from their sales pays for public projects like monuments,
bridges and national parks. Unlike other
bonds, the U.S. government does not issue payments to bond holders at regular
intervals. The buyer purchases the bond
for less than par value instead. For
example, an investor can buy a $100 savings bond for $50. When it matures, the bondholder receives $50
as repayment for the principal and $50.00 in interest.
An Example of a United States Savings Bond
Ø Treasury Bonds, Bills and Notes: Treasury bonds, bills (T-bills) and notes
(T-notes) represent other opportunities to invest through the United States
Treasury Department. Investors can
purchase them for a minimum of $1000.
Because they are backed by the federal government, there is little risk
to the investor. Treasury bonds are
considered long-term investments because they mature anywhere from ten to
thirty years. Since they reach their
value in two to ten years, economists regard T-notes as intermediate-term
investments. On the other hand, T-bills
mature in three to twelve months and are labeled as short-term investments. To learn more about bonds issued by the
federal government, click on the icon below.
Ø Municipal Bonds:
State and local governments also sell bonds to fund new schools, to
improve roads and to complete other public works. These are referred to as municipal bonds, or munis. Standard and Poor's and Moody's classify
these as reasonably safe investments.
This is based on the fact that state and local governments have the
authority to collect taxes. Therefore,
these governments are likely to keep up with interest payments and to repay the
loan when it matures. Any interest on
these bonds is not considered taxable income, and this is an added bonus for
investors. The graphic below shows a
list of municipal bonds for sale along with their ratings, the number
available, the coupon, maturity and price.
Information Courtesy of fms,bonds inc.
Ø Corporate Bonds:
Corporations sometimes raise money by issuing bonds. Unlike governments, they have no tax base to
help guarantee repayment. Corporations
depend on their profits from sales of goods and services to repay their debts. Sales, however, may not increase as anticipated. For this reason, most corporate bonds have
moderate potential for risk. Bondholders
also pay income tax on any interest payments that they receive. To eliminate
fraud and other dishonest practices, the Securities
and Exchange Commission (SEC), an independent agency of the federal
government, carefully monitors companies that borrow money by offering bonds.
The United
States Securities and Exchange Commission:
Washington D.C.
Ø Junk Bonds: In
the 1980s and 1990s, junk bonds became a popular option for aggressive
investors. Investors purchase these low-rated bonds because the corporations
that issue them are willing to pay higher interest rates to borrow money. They have the potential to produce a much
higher return than federal, municipal or corporate bonds. However, there is also reason to believe that
the company issuing these bonds will default, and the bondholder will lose his
or her investment.
Go to Questions 11
through 22.
what
What
Happens next?
Bonds
represent one way that corporations raise money to produce goods and
services. They may also choose to sell
shares of stock in their businesses.
This not only provides cash to start, maintain and expand production but
also gives investors an opportunity to make a profit. As with all investments, however, buying stock
comes with risk. Before exploring this
topic in the next unit, review the terms found in Unit 10; then, answer
Questions 23 through 32.
Go to Questions 23
through 32.
 |
| Unit 10 Main Points Worksheet |
| Unit 10 Crossword: What To Do With All That Money |