exercise 2.1

Objectives

· understand the importance of saving and the differences (advantages and disadvantages) between certificates of deposit (CDs), checking, and savings accounts.

· understand the difference between simple and compound interest.

Checking accounts give individuals the easiest access to their funds via checks, but pay little or no interest. Indicate that most banks require students of middle school age to have a parent as a cosigner when opening a checking account. Individuals also have access to their funds via their debit cards.

Savings accounts provide some interest but require the individual to visit a bank branch, use a debit card at an ATM, or go online to have access to his or her funds.

Certificates of deposit (CDs) have the advantage of offering higher interest rates than savings accounts, but have tighter restrictions on access to funds. Individuals purchasing a CD must commit to holding it for a period of time, generally ranging from six months to five years or more. Selecting the term of a CD involves some risk. When a long-term CD is purchased and interest rates later go up, the purchaser only receives the interest rate stated at the time of purchase. If it turns out that interest rates go down, the purchaser will be happy to have locked in a favorable rate.

Interest is sometimes calculated as simple interest but is more frequently calculated as compound interest. Provide an example of each, explaining each formula:

· The simple interest formula is I = PRT, where I is the amount of interest earned, Pis the amount deposited (principal), R is the rate of interest, and T is the number of years. So if you deposited $100 for two years with an interest rate of 3½%, you would earn $100 x .035 x 2 or $7. (If necessary, explain how 3½% is converted to .035 in the calculation.)

· The compound interest rate formula is A = P(1 + r/n)nt, where A is the ending amount, P is the amount deposited (principal), r is the interest rate, n is the number of compounding periods per year, and t is the number of years. The amount of interest earned is the ending amount minus the principal invested (A - P). Give an example of annual compounding.

· If you deposit $100 for two years at 3½% interest, you would end up with 100 x (1 + .035)2 or $107.12, representing the initial deposit plus interest. If appropriate for your class, use the same example but have the interest compounded quarterly (100 x (1 +.035/4)2x4 or $107.22 (rounded to the nearest cent) representing the initial deposit plus interest. Note how quarterly compounding results in higher interest income.