8.3: Savings Accounts And Short-Term GICs
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When the stock market offers potentially huge returns, why would anyone put money into an investment that earns just a few percent annually? The answer of course is that sometimes stocks decrease in value. For example, after reaching a historic high in June 2008, the Toronto Stock Exchange plunged 40% over the course of the next six months. So if you are not willing to take the risk in the stock market, there are many options for investing your money that are safe and secure, particularly savings accounts and short-term guaranteed investment certificates (GICs). Some of the benefits and drawbacks associated with safe and secure investments are listed below.
Benefits
- Investments are virtually 100% safe, meaning that the chances of losing your investment are almost zero.
- They always have a positive rate of interest.
- It is easy to access the money when the investor needs it.
- Any interest earned is better than zero interest.
- It is suitable for small amounts.
Drawbacks
- Interest rates are extremely low and offer little growth for your money.
- Many come with stiff fees and interest rate penalties if certain conditions are not met.
- Minimum balances are a common requirement, otherwise the interest rate is zero.
- Balances are only insured up to $100,000.
In this section, you are exposed to both savings accounts and short-term GICs. You will learn a little about the characteristics of each along with how to perform simple interest calculations on these financial tools.
Savings Accounts
A savings account is a deposit account that bears interest and has no stated maturity date. These accounts are found at most financial institutions, such as commercial banks (Royal Bank of Canada, TD Canada Trust, etc.), trusts (Royal Trust, Laurentian Trust, etc.), and credit unions (FirstOntario, Steinbach, Assiniboine, Servus, etc.). Owners of such accounts make deposits to and withdrawals from these accounts at any time, usually accessing the account at an automatic teller machine (ATM), at a bank teller, or through online banking.
A wide variety of types of savings accounts are available. This textbook focuses on the most common features of most savings accounts, including how interest is calculated, when interest is deposited, insurance against loss, and the interest rate amounts available.
- How Interest Is Calculated. There are two common methods for calculating simple interest:
- Accounts earn simple interest that is calculated based on the daily closing balance of the account. The closing balance is the amount of money in the account at the end of the day. Therefore, any balances in the account throughout a single day do not matter. For example, if you start the day with $500 in the account and deposit $3,000 at 9:00 a.m., then withdraw the $3,000 at 4:00 p.m., your closing balance is $500. That is the principal on which interest is calculated, not the $3,500 in the account throughout the day.
- Accounts earn simple interest based on a minimum monthly balance in the account. For example, if in a single month you had a balance in the account of $900 except for one day, when the balance was $500, then only the $500 is used in calculating the entire month's worth of interest.
- When Interest Is Deposited. Interest is accumulated and deposited (paid) to the account once monthly, usually on the first day of the month. Thus, the interest earned on your account for the month of January appears as a deposit on February 1.
- Insurance against Loss. Canadian savings accounts at commercial banks are insured by the national Canada Deposit Insurance Corporation (CDIC), which guarantees up to $100,000 in savings. At credit unions, this insurance is usually provided provincially by institutions such as the Deposit Insurance Corporation of Ontario (DICO), which also guarantees up to $100,000. This means that if your bank were to fold, you could not lose your money (so long as your deposit was within the maximum limit). Therefore, savings accounts carry almost no risk.
- Interest Rate Amounts. Interest rates are higher for investments that are riskier. Savings accounts carry virtually no risk, which means the interest rates on savings accounts tend to be among the lowest you can earn. At the time of writing, interest rates on savings accounts ranged from a low of 0.05% to a high of 1.95%. Though this is not much, it is better than nothing and certainly better than losing money!
While a wide range of savings accounts are available, these accounts generally follow one of two common structures when it comes to calculating interest. These structures are flat rate savings accounts and tiered savings accounts. Each of these is discussed separately.
How It Works
Flat-Rate Savings Accounts.
A flat-rate savings account has a single interest rate that applies to the entire balance. The interest rate may fluctuate in synch with short-term interest rates in the financial markets.
Follow these steps to calculate the monthly interest for a flat-rate savings account:
Step 1: Identify the interest rate, opening balance, and the monthly transactions in the savings account.
Step 2: Set up a flat-rate table as illustrated here. Create a number of rows equaling the number of monthly transactions (deposits or withdrawals) in the account plus one.
| Date | Closing Balance in Account | # of Days | Simple Interest Earned |
|---|---|---|---|
| \(I=Prt\) | |||
| Total Monthly Interest Earned | |||
Step 3: For each row of the table, set up the date ranges for each transaction and calculate the balance in the account for each date range.
Step 4: Calculate the number of days that the closing balance is maintained for each row.
Step 5: Apply Formula 8.1, \(I = Prt\), to each row in the table. Ensure that rate and time are expressed in the same units. Do not round off the resulting interest amounts (\(I\)).
Step 6: Sum the Simple Interest Earned column and round off to two decimals.
When you are calculating interest on any type of savings account, pay careful attention to the details on how interest is calculated and any restrictions or conditions on the balance that is eligible to earn the interest.
The RBC High Interest Savings Account pays 0.75% simple interest on the daily closing balance in the account and the interest is paid on the first day of the following month. On March 1, the opening balance in the account was $2,400. On March 12, a deposit of $1,600 was made. On March 21, a withdrawal of $2,000 was made. Calculate the total simple interest earned for the month of March.
Solution
Calculate the total interest amount for the month (\(I\)).
What You Already Know
Step 1:
The following transactions, dates, and interest rate are known: \(r = 0.75\%\) per year, March 1 opening balance = $2,400, March 12 deposit = $1,600, March 21 withdrawal = $2,000
How You Will Get There
Step 2:
Set up a flat-rate table.
Step 3:
Determine the date ranges for each balance throughout the month and calculate the closing balances.
Step 4:
For each row of the table, calculate the number of days involved.
Step 5:
Apply Formula 8.1 to calculate simple interest on each row.
Step 6:
Sum the Simple Interest Earned column.
| Dates | Closing Balance in Account | # of Days | Simple Interest Earned (I = Prt) |
|---|---|---|---|
| Step 2 and Step 3 | Step 4 | Step 5 | |
| March 1 to March 12 | $2,400 | 12 − 1 = 11 | \(\begin{aligned} &I=\$ 2,400(0.0075)\left(\dfrac{11}{365}\right)\\ &I=\$ 0.542465 \end{aligned} \) |
| March 12 to March 21 | $2,400 + $1,600 = $4,000 | 21 − 12 = 9 | \(\begin{aligned} &I=\$ 4,000(0.0075)\left(\dfrac{9}{365}\right)\\ &I=\$ 0.739726 \end{aligned} \) |
| March 21 to April 1 | $4,000 − $2,000 = $2,000 | 31 + 1 − 21 = 11 | \(\begin{aligned} &I=\$ 2,000(0.0075)\left(\dfrac{11}{365}\right)\\ &I=\$ 0.452054 \end{aligned} \) |
| Step 6: Total Monthly Interest Earned | \(\begin{aligned} I&=\$0.542465+\$0.739726+\$0.452054 \\ I&=\$ 1.73 \end{aligned} \) |
||
For the month of March, the savings account earned a total simple interest of $1.73, which was deposited to the account on April 1.
How It Works
Tiered Savings Accounts.
A tiered savings account pays higher rates of interest on higher balances in the account. This is very much like a graduated commission on gross earnings, as discussed in Section 4.1. For example, you might earn 0.25% interest on the first $1,000 in your account and 0.35% for balances over $1,000. Most of these tiered savings accounts use a portioning system. This means that if the account has $2,500, the first $1,000 earns the 0.25% interest rate and it is only the portion above the first $1,000 (hence, $1,500) that earns the higher interest rate.
Follow these steps to calculate the monthly interest for a tiered savings account:
Step 1: Identify the interest rate, opening balance, and the monthly transactions in the savings account.
Step 2: Set up a tiered interest rate table as illustrated below. Create a number of rows equaling the number of monthly transactions (deposits or withdrawals) in the account plus one. Adjust the number of columns to suit the number of tiered rates. Fill in the headers for each tiered rate with the balance requirements and interest rate for which the balance is eligible.
| Dates | Closing Balance in Account | # of Days | Tier Rate #1 Balance Requirements and Interest Rate | Tier Rate #2 Balance Requirements and Interest Rate | Tier Rate #3 Balance Requirements and Interest Rate |
|---|---|---|---|---|---|
| Eligible P = I = Prt | Eligible P = I = Prt | Eligible P = I = Prt | |||
| Total Monthly Interest Earned | |||||
Step 3: For each row of the table, set up the date ranges for each transaction and calculate the balance in the account for each date range.
Step 4: For each row, calculate the number of days that the closing balance is maintained.
Step 5: Assign the closing balance to the different tiers, paying attention to whether portioning is being used. In each cell with a balance, apply Formula 8.1, where \(I = Prt\). Ensure that rate and time are expressed in the same units. Do not round off the resulting interest amounts (\(I\)).
Step 6: To calculate the Total Monthly Interest Earned, sum all interest earned amounts from all tier columns and round off to two decimals.
The Rate Builder savings account at your local credit union pays simple interest on the daily closing balance as indicated in the table below:
| Balance | Interest Rate |
|---|---|
| $0.00 to $500.00 | 0% on entire balance |
| $500.01 to $2,500.00 | 0.5% on entire balance |
| $2,500.01 to $5,000.00 | 0.95% on this portion of balance only |
| $5,000.01 and up | 1.35% on this portion of balance only |
In the month of August, the opening balance on an account was $2,150.00. Deposits were made to the account on August 5 and August 15 in the amounts of $3,850.00 and $3,500.00. Withdrawals were made from the account on August 12 and August 29 in the amounts of $5,750.00 and $3,000.00. Calculate the simple interest earned for the month of August.
Solution
Calculate the total interest amount for the month of August (\(I\)).
What You Already Know
Step 1:
The interest rate structure is in the table above.
The transactions and dates are also known:
August 1 opening balance = $2,150.00, August 5 deposit = $3,850.00, August 12 withdrawal = $5,750.00, August 15 deposit = $3,500.00, August 29 withdrawal = $3,000.00
How You Will Get There
Step 2:
Set up a tiered interest rate table with four columns for the tiered rates.
Step 3:
Determine the date ranges for each balance throughout the month and calculate the closing balances.
Step 4:
Calculate the number of days involved on each row of the table.
Step 5:
Assign the closing balance to each tier accordingly. Apply Formula 8.1 to any cell containing a balance.
Step 6:
Total up all of the interest from all cells of the table.
Perform
| Dates | Closing Balance in Account | # of Days | 0% $0 to $500 Entire Balance | 0.5% $500.01 to $2,500 Entire Balance | 0.95% $2,500.01 to $5,000 This portion only | 1.35% $5,000.01 and up This portion only |
|---|---|---|---|---|---|---|
| Step 2 and Step 3 | Step 4 | Step 5 | ||||
| August 1 to August 5 | $2,150.00 | 5 − 1 = 4 | \(\begin{aligned} &P=\$2,150.00\\ &I=\$ 2,150(0.005)\left(\dfrac{4}{365}\right)\\ &I=\$ 0.117808 \end{aligned}\) |
|||
| August 5 to August 12 | $2,150.00 + $3,850.00 = $6,000.00 | 12 − 5 = 7 | \(\begin{aligned} &P=\$2,500.00\\ &I=\$2,500(0.005)\left(\dfrac{7}{365}\right)\\ &I=\$ 0.239726 \end{aligned}\) |
\(\begin{aligned} &P=\$2,500.00\\ &I=\$ 2,500(0.0095)\left(\dfrac{7}{365}\right)\\ &I=\$ 0.455479 \end{aligned}\) |
\(\begin{aligned} &P=\$1,000.00\\ &I=\$ 1,000(0.0135)\left(\dfrac{7}{365}\right)\\ &I=\$ 0.258904 \end{aligned}\) |
|
| August 12 to August 15 | $6,000.00 − $5,750.00 = $250.00 | 15 −12 = 3 | P = $250.00 I = $0.00 | |||
| August 15 to August 29 | $250.00 + $3,500.00 = $3,750.00 | 29 − 15 = 14 | \(\begin{aligned} &P=\$ 2,500.00\\ &I=\$2,500(0.005)\left(\dfrac{14}{365}\right)\\ &I=\$ 0.479452 \end{aligned}\) |
|||
| August 29 to September 1 | $3,750.00 − $3,000.00 = $750.00 | 31 + 1 − 29 = 3 | \(\begin{aligned} &P=\$ 750.00\\ &I=\$ 750(0.005)\left(\dfrac{3}{365}\right)\\ &I=\$ 0.030821 \end{aligned}\) |
|||
| Step 6: Total Monthly Interest Earned | \(\begin{aligned} &I=\$0.117808+\$0.239726+\$0.455479+\$ 0.258904+\$ 0.00+\$0.479452+\$ 0.455479+\$ 0.030821\\ &I=\$ 2.04 \end{aligned}\) |
|||||
For the month of August, the tiered savings account earned a total simple interest of $2.04, which was deposited to the account on September 1.
Short-Term Guaranteed Investment Certificates (GICs)
A guaranteed investment certificate (GIC) is an investment that offers a guaranteed rate of interest over a fixed period of time. In many countries around the world, a GIC is often called a time or term deposit. GICs are found mostly at commercial banks, trust companies, and credit unions. Just like savings accounts, they have a very low risk profile and tend to have much lower rates than are available through other investments such as the stock market or bonds. They are also unconditionally guaranteed, much like savings accounts. In this section, you will deal only with short-term GICs, defined as those that have a time frame of less than one year.
The table below summarizes three factors that determine the interest rate on a short-term GIC: principal, time, and redemption privileges.
| Higher Interest Rates | Lower Interest Rates | |
|---|---|---|
| Principal Amount | Large | Small |
| Time | Longer | Shorter |
| Redemption Privileges | Nonredeemable | Redeemable |
- Amount of Principal. Typically, a larger principal is able to realize a higher interest rate than a smaller principal.
- Time. The length of time that the principal is invested affects the interest rate. Short-term GICs range from 30 days to 364 days in length. A longer term usually realizes higher interest rates.
- Redemption Privileges. The two types of GICs are known as redeemable and nonredeemable. A redeemable GIC can be cashed in at any point before the maturity date, meaning that you can access your money any time you want it. A nonredeemable GIC "locks in" your money for the agreed-upon term. Accessing that money before the end of the term usually incurs a stiff financial penalty, either on the interest rate or in the form of a financial fee. Nonredeemable GICs carry a higher interest rate.
To summarize, if you want to receive the most interest it is best to invest a large sum for a long time in a nonredeemable short-term GIC.
How It Works
Short-term GICs involve a lump sum of money (the principal) invested for a fixed term (the time) at a guaranteed interest rate (the rate). Most commonly the only items of concern are the amount of interest earned and the maturity value. Therefore, you need the same four steps as for single payments involving simple interest shown in Section 8.2.
Your parents have $10,000 to invest. They can either deposit the money into a 364-day nonredeemable GIC at Assiniboine Credit Union with a posted rate of 0.75%, or they could put their money into back-to-back 182-day nonredeemable GICs with a posted rate of 0.7%. At the end of the first 182 days, they will reinvest both the principal and interest into the second GIC. The interest rate remains unchanged on the second GIC. Which option should they choose?
Solution
For both options, calculate the future value (\(S\)), of the investment after 364 days. The one with the higher future value is your parents' better option.
What You Already Know
Step 1:
For the first GIC investment option: \(P = \$10,000, r = 0.75\%\) per year \(t = 364\) days
For the second GIC investment option: Initial \(P = $10,000, r = 0.7\%\) per year \(t = 182\) days each
How You Will Get There
Step 2:
The rate is annual, the time is in days. Convert the time to an annual number.
Step 3 (1st GIC option):
Calculate the maturity value (\(S_1\)) of the first GIC option after its 364-day term by applying Formula 8.2.
Step 3 (2nd GIC option, 1st GIC):
Calculate the maturity value (\(S_2\)) after the first 182-day term by applying Formula 8.2.
Step 3 (2nd GIC option, 2nd GIC):
Reinvest the first maturity value as principal for another term of 182 days applying Formula 8.2 and calculate the final future value (\(S_3\)).
Perform
Step 2:
Transforming both time variables, \(t=\dfrac{364}{365}\) and \(t=\dfrac{182}{365}\)
Step 3 (1st GIC option): \(S_{1}=\$ 10,000\left(1+(0.0075)\left(\dfrac{364}{365}\right)\right)=\$ 10,074.79\)
Step 3 (2nd GIC option, 1st GIC): \(S_{2}=\$ 10,000\left(1+(0.007)\left(\dfrac{182}{365}\right)\right)=\$ 10,034.90 \)
Step 3 (2nd GIC option, 2nd GIC): \(S_{3}=\$ 10,034.90\left(1+(0.007)\left(\dfrac{182}{365}\right)\right)=\$ 10,069.93\)
The 364-day GIC results in a maturity value of $10,074.79, while the two back-to-back 182-day GICs result in a maturity value of $10,069.93. Clearly, the 364-day GIC is the better option as it will earn $4.86 more in simple interest.