Let’s be frank. The topic of interest on money is anything but interesting. You can’t spend a minute talking about it without nodding off. It’s what insomniacs think about as a last resort.
So let’s not talk about interest. Let’s talk about renting money.
Like any rental arrangement, money rental features two parties: owner and renter. When you own money, you can rent it to people who don’t. You get paid a rental fee, which means you get to own and rent out even more money. Let’s explore how it works.
An Unlikely Story
While driving home on a rainy night, you spot a sweet old lady standing by the side of her car, trying to fix a flat tire. You stop and fix it for her. Overwhelmed by your kindness, she gives you a hug and hands you $10,000. Cash. You try to refuse, but she insists. A glance at her car, clothes and jewelry tells you that ten grand is probably just pocket change to her, so you finally give in and take the wad of cash with her thanks.
The next morning, when the shock of your good fortune subsides, you march down to the bank, open a savings account and deposit the whole thing. The banker tells you, “This account is 6 percent APR, compounded monthly, with an annual yield of 6.17 percent.” You have no idea what she’s saying. But you nod your head, shake her hand, then run out to tell your friends your Capitalist Samaritan tale. Meanwhile, the banker stuffs your money into an envelope with your name on it, then hides it in the bank vault.
Congratulations — you’ve just gone into the money-rental business. Here’s how it works. As a rule (actually, a federal law), most money rentals are priced on a percentage of the amount rented over a one-year rental period. This is true even if the money is returned before a year is up. In your case, the annual rental rate is 6 percent. In the money-rental world, they call this the APR, or annual percentage rate.
The second thing the banker said, compounded monthly, just means that the rent is paid every month. The annual rental rate is 6 percent, so the monthly rate is one twelfth of that, or 0.5 percent. But here’s a strange thing: The bank won’t be sending you rent checks. They’ll just deposit the rent into the account itself. (That’s what compounded means.)
And then there’s that yield business. It’s different than the APR because the bank puts the rent payments into your account instead of sending you a check each month. This is the confusing part, so let’s get back to the story where it will make more sense.
Enter Harold. One month after you make your big deposit, this trustworthy bank employee takes his calculator into the bank vault to count the money in your envelope. Harold multiplies $10,000 by the monthly rental rate of 0.5 percent. This comes to $50, which he takes from a money bag and puts into your envelope. Rent paid.
The next month Harold is at it again. He counts the money in your envelope: $10,050. Then he multiplies it by 0.5 percent to get the monthly rental fee. This time it’s $50.25 — one shiny quarter more than last month’s rent. He adds this amount to your envelope. Harold pays the rent like this every month for an entire year. (Actually, one time he was sick so Hector did it.) Every rent payment is higher than the last one because the bank keeps putting the rent in your envelope, and must then pay rent on the rent the next month. The rent keeps piling up, or compounding, which I suppose is why they call it that.
Let’s cut to the chase. At the end of the year, you withdraw your money. Out of the vault comes your envelope containing the original $10,000 plus $616.78 in rental income. Wait a minute. Six percent of $10,000 is just $600. Harold messed up. He overpaid you by $16.78. Not really. The extra amount is all the rent you received on the rent. Had the bank sent you rent checks each month instead of putting the rent into your account, there would simply be no rent on rent. Which is why they call that kind of rent payment simple.
This is where the yield figures in. Yield is a useful term that money people stole from farmers. It’s used to describe the amount of produce actually harvested from what’s been planted. In money-rentals, it refers to what was returned in comparison to what was rented. The bank rented your $10,000, then returned $10,616.78. So the actual rental rate came to 6.17 percent. That’s the yield. It’s rent plus rent on rent. And it’s a very good thing — when you’re the one on the receiving end.
Since the yield is affected by the rent paid on rent, it changes according to the rental payment schedule. For example, if the bank made just one big rent payment at the end of the year — that is, if Harold made just one trip to the vault — they’d pay no rent on the rent. You’d just get the straight 6 percent rental fee, or $600. In this case, the yield — 6 percent — is the same as the APR. The bank would call this kind of rental arrangement annual compounding. You can call it less profitable. Harold just calls it boring.
So let’s see what would happen if the bank paid the rent daily — something called daily compounding. This would keep Harold busy, adding $1.64 to your envelope each day for the first few days, working his way up to $1.75 daily by the end of the year. The bank would give you back the ten grand plus $618.31 in accumulated rent payments — about a buck and a half more than with monthly rent payments. Your yield: 6.18 percent.
OK, so it’s not much of an improvement, but it does show that the same annual rental rate, or APR if you prefer, pays different actual rental fees, depending on how often the rent is paid. For example, you might find two accounts with the same APR, but one pays rent every month while the other pays just quarterly. The former will have a higher yield. So when you rent out your money, forget about APRs. Pay attention to the yields. Higher is better.
Banks don’t typically pay rent daily, so you’re probably not going to find such a deal with them. But they’re very familiar with this kind of arrangement — it’s how they charge rent on credit card balances. If you don’t pay off your credit card in full each month, you pay daily rent on the balance — a balance that includes any unpaid rent. Why do they charge rent daily, but pay it only monthly? Because it’s better for them. Those few extra pennies or dollars each month keep accumulating, allowing them to charge you rent on rent on rent on … well, you get the picture. There’s just one way to avoid this snare: Pay your balance in full each month. Then you pay no rent at all. When you’re the renter, this is a very good thing.
Some Fine Print
Before we go on, I need to set some things straight: First, you probably won’t see 6 percent rental rates at your bank — at least till the current economy changes. I just chose that number because it made my math easier and all those decimal figures less daunting.
Second, banks that pay rent monthly prefer to do their payment calculations with something called the average daily balance. It works like this: Harold makes a daily trip to the vault to count your money. He records the amount on a piece of paper. At the end of the month, he adds up all those daily figures, then divides the total by the number of days in that month. That’s the average daily balance. Then he pays the monthly rent on that average. If the bank paid rent the way I described in the story, you could deposit a bunch of money right before Harold took his monthly trip to the vault, then withdraw it after he had paid the rent on that inflated balance. The average daily balance prevents this sneaky trick. (Apparently, I wasn’t the first person to think of it.)
Third thing. Unlike your landlord, banks don’t figure rent on calendar months. They just use a 30- or 31-day statement period that could begin on any day of the month. This spreads out Harold’s workload so that he doesn’t have to pay everyone’s rent on the same day.
Fourth, Harold doesn’t work at the bank anymore. He was replaced by a computer. I know … it’s sad.
And last, your money’s not in the vault. After all, the bank is in the money-rental business too. They rented your ten grand to a guy who’s putting a swimming pool in his back yard. He’s paying rent for that money at a rate much higher than you’re getting. The bank makes a profit on the difference. And you don’t even get to swim in his pool.
Long Term Rentals
The rewards of renting out your money pile up when you continue adding money to your rental inventory and keep it there for the long haul. That is, you keep making regular deposits to a savings account and make no withdrawals. Let’s use a more realistic example this time:
Starting today, you make a commitment to rent $100 to the bank — and to rent out another $100 every month from now on. The account has a 4 percent annual rental rate, paid monthly, figured on the average daily balance. Over time, here’s what your money-rental business will grow to:
|year||total deposits||+ total rent||=balance|
Of course, you’ll soon be able to invest more than $100 a month. And you’re likely to find more profitable ways to rent out your money, such as money market accounts, certificates of deposit, and bonds. Over time, it’s not hard to take in two to 10 times these amounts in rent.
And remember, this is just rental income on your money. We haven’t even talked about trading, where you swap your money for a house or stock in a company or shares in a mutual fund, then trade the asset to someone who’s willing to swap more cash for it than you did. We’ll save this trick for another column.
For right now, invest by renting your money to the bank. It’s easy, the rent is guaranteed, and the bank makes all the rent payments straight into your account. Make a savings account deposit every month. Twice a month if you get paid that way. If you have a tendency to spend away your income on unnecessary things, make a bank run weekly. They’ll pay you rent for every penny, and even pay rent on the rent.
There. I made it all the way through this explanation without using that boring “I” word. Because I didn’t want to lose your … well, you know.
This article originally ran in November 1999. Some of the numbers are out of date, but the principles are still good!
Copyright 2002 Todd Temple. All rights reserved.