Comprehensive Guide to Savings, Investment, and Borrowing

Fundamental Principles of Saving

Saving is fundamentally defined as the act of spending less than your total income and putting a portion of that income into a designated place. It is a critical component of financial planning to ensure that you spend less than you earn. There are several primary reasons why individuals choose to save money. First, it allows for the purchase of items for future events. Second, it provides a financial buffer for unforeseen events or unexpected expenses. Third, it ensures that money is available for future needs. Fourth, it is a key strategy for retirement, allowing individuals to have extra money available when they retire. Finally, saving allows an individual to receive interest, which is an amount that financial institutions add to savings each year as a reward for saving with them.

Financial Institutions for Savings

There are two primary types of financial institutions discussed for holding savings: Credit Unions and Commercial Banks. A Credit Union is a financial institution owned by its members, and those members can earn dividends on their savings. A Commercial Bank is owned by stockholders, and savers earn interest on their deposits. Commercial Banks are subject to the Deposit Guarantee Scheme, which provides protection for depositors. Financial institutions also facilitate loans. Additionally, DIRT (Deposit Interest Retention Tax) is a tax that applies to the interest earned on savings.

Mechanics of Interest and Investment

Interest on savings is calculated using a specific formula involving three variables: Principal ($P$) multiplied by Rate ($R$) multiplied by Time ($T$). The Principal ($P$) is the original sum of money saved. The Rate ($R$) represents the annual interest rate, and Time ($T$) is the number of years the money is saved. There is a distinction between Simple Interest and Compound Interest. Simple Interest is based on a fixed percentage applied to the original amount without adding any accumulated interest. It is calculated as the yearly interest ($YI$) multiplied by the number of years. Compound Interest, however, takes into account interest that has already been added to the account from the previous year before calculating the interest for the current year. It is computed on the sum of the original amount and interest received.

The Annual Equivalent Rate (AER), also known as the Compound Annual Rate (CAR), is the actual annual interest rate an account earns based on compound interest. Beyond simple savings, an individual might engage in investing. Investing means using your money in the hope of making a profit, and examples include buying company shares, buying property, or placing money in an investment fund.

Principles of Borrowing and APR

Borrowing occurs when individuals need funds for several reasons: to make an expensive purchase they cannot afford from current savings, to start a new business, to help them through an expensive period of time, to make an investment they hope will yield a profit (such as attending college), or to cover an emergency. When borrowing, the cost of the loan is expressed as the Annual Percentage Rate (APR). The APR is the actual rate of interest charged on a loan each year. This rate takes into account that the total amount of the loan decreases each year as the loan is being repaid.

Classification of Borrowing by Duration

Borrowing is categorized into three distinct timeframes: Short-term, Medium-term, and Long-term. Short-term borrowing covers a period of up to $1$ year. Examples of short-term credit include bank overdrafts, credit or store cards, and money lenders. Common uses for short-term borrowing are holiday expenses or school costs. Medium-term borrowing covers a duration of $1$ to $5$ years. Examples include term loans, personal loans, hire purchase agreements, or renting. These are typical for purchases like a car or a new kitchen. Long-term borrowing is defined as credit lasting over $5$ years. This category includes mortgages and other long-term loans, which are typically used for significant investments like a new house or an attic conversion.