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Why Is Interest A Good Thing?

Interest is a good thing because it is the incentive that individual institutions use so you will let them borrow your money and then use for issuing loans. What that means in the most simple terms is that when you allow someone to use your money there has to be a reason for you to do so. If a friend comes to you and wants to borrow $1,000 you could lend them the money out of altruism but in reality most loans have an interest rate. The interest you will learn is the incentive for you to loan the money. If they agree to pay you 5% interest then that means after a month when they repay the $1,000 there will also be an additional $50. Now most individuals do not normally act as lenders for things like mortgage and automobile loans. But when you put your money in a bank most institutions will pay interest on the deposits as an incentive to get your business.

Initially most financial institutions such as banks and credit unions only offered interest on savings accounts and some high-end checking accounts. As more and more consumers became financially educated about various investment vehicles these institutions realized they could get more money from consumers by offering higher interest for different investments. Over time these institutions added investment tools such as money market accounts and certificates of deposit. A money market account is essentially a really fancy checking account that offers slightly higher interest. Certificates of deposit however can offer significantly higher interest because of the one factor that makes them less liquid which is a penalty if the certificate is canceled prior to its maturity date. So if a consumer has $10,000 in a savings account and decides to take $5,000 of that and purchase a 12 month certificate of deposit they will get a higher return on the CD but will pay a penalty if they cancel it prior to its maturing in 12 months.

For individuals with large cash balances it makes sense to move money around so they can earn more interest. One of these moves can entail creating an Individual Retirement Account or IRA which holds within it a money market account. If $100,000 is put into an IRA money market account then the interest which accumulates can grow tax-free until disbursement begins at age 65. This is an important concept because normally interest is taxed every year as earned income so you can have large amounts of tax-deferred interest accumulate over decades which can add up very quickly.

As you can see interest is a very good thing for individuals because without this incentive you might as well keep your money in a bundle under your mattress. The reason why banks and credit unions pay interest is because they make money on the difference between what they pay to account holders and what they charge for mortgage and automobile loans. It would be nice to get a bigger cut of the money they make from these various loans but since accounts are FDIC insured bank holders assume no risk in the loans extended to others. As with all investments in life there is a strong risk to reward correlation and if account holders want more interest than what is offered on a savings account they would need to make different investment decisions and purchase stocks and bonds or precious metals and real estate. At a minimum though it's nice to know that the cash you have in a savings account is doing something even if it doesn't seem like it's doing very much.