CESI Personal Finance Guide - Chapter 2: Banking Basics
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Chapter 2: Banking Basics
If you are someone who doesn’t understand finance or banking, this chapter hopes to simplify the banking jargon and provide you with the basics. A bank is an institution where you put your money. It helps you carry out routine money transactions like transferring funds, recording where your funds are going, paying your bills, depositing your salary, and enabling you to save money in a structured way. Apart from these transactions, banks also offer accounts for savings, checking, loans, credit cards, and investment instruments.
Why Should I Bank?
You may be stashing your savings in piggy banks or shoe boxes! Or, you may be using check cashing services that charge you hefty fees. Whatever the case, sooner or later the shoe box or piggy bank is going to fill up or you will need to write a check. Without a banking account, your options are quite limited. You are at the mercy of whatever fees somebody wants to charge to cash your paycheck or give you a money order. If you are thinking of keeping your money at home in a piggy bank, consider this:
- Your money will not grow (i.e. you will get no returns in terms of interest).
- If a disaster like a robbery or a fire occurs in your home, all your money will vanish.
On the other hand, if you put your money in a bank, it will increase in value, earn some interest and grow. Also, money deposited in the bank is safe because your account is insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor (through 12/2013). Some additional advantages to having a bank account include:
- Many employers offer direct deposit of your paycheck to your bank account saving you the hassle of driving around and paying fees to access your money.
- The majority of banks offer online banking at no cost to their account holders. Online banking allows you to have 24-hour access to your accounts to transfer money, pay bills and check your balances.
- Having and properly maintaining a bank account can help you to build or improve your credit.
Before you put your money in the bank, it is prudent to know how a bank operates and how it makes your money grow.
How a Bank Works
Banks are important to the growth of our economy. Their primary function is to make your money work harder and generate more money for you. When you deposit your money in the bank, your account is credited (money added) with the amount of your deposit. When you issue checks towards any bill payment or make cash withdrawals for personal use, that amount is debited (deducted) from your account balance. The balance that remains in your savings or interest bearing checking account earns interest which in turn is added to your account.
How does the balance in your account earn interest? In addition to safeguarding your money and helping you save money, banks also lend money to people or businesses to fulfill their needs like buying a house, paying for college, or starting and expanding a business. The money that the banks use to give the borrowers comes from the combined pool of the money deposited by you and other consumers. This money is lent to borrowers at a higher rate of interest than the interest you get as a depositor with the bank. For example, the rate of interest you get on your savings account may be 3% and the rate of interest that you pay to the bank if you take a loan might be 8%. When you repay your loan, the bank earns the difference of 5% after paying you 3% for using your money to lend money to borrowers.
The amount of the money that the bank can lend is regulated by the Federal Reserve. Presently, the reserve requirement set by the Federal Reserve is 3% to 10% of the bank’s total deposits.
How does this affect our economy? Let’s consider this example: when a bank receives a deposit of $100, the bank can lend $90 (assuming the reserve requirement of 10 percent). This $90 goes back into the economy as a loan for buying goods or services, and usually ends up deposited in another bank.
Suppose you take an auto loan from your bank to buy a car and you pay the car manufacturer that amount. The manufacturer will in turn deposit that money with another bank. Again, this bank can go on to loan the amount after keeping a reserve of 10%.
Not all banks offer the same services. It would be wise to shop around for the right bank based on your requirements. However, do keep in mind a few things like:
- Find out the law applicable in your state regarding banking services. In some states like Massachusetts, the law prohibits the banks from charging fees on a savings account held by individuals below the age of 18 and above the age of 65.
- Check if the bank pays a competitive interest rate to the depositors.
- Find out if the bank is charging any monthly fees and the possibility of having those fees waived (such as with a minimum balance requirement or direct deposit setup).
- Find out if the location of the bank suits you as well as its business hours.
- Double-check that your deposit is insured by Federal Deposit Insurance Corporation (FDIC).
- Ensure that the bank is a socially responsible institution that takes an interest in investing in community development.
- Find out from existing customers about the bank’s reputation in terms of courtesy and efficiency.
Once you finalize your bank choice, opening an account is usually quite simple. The person opening your account will verify your identity by asking you to supply a couple of different forms of identification. You will need to fill out your signature card with your personal details like your name, address, date of birth, Social Security Number (SSN), and telephone number.
Once you have completed all the form filling and signature card formalities, you will be given your bank book listing the total amount of money held in your account.
Types of Deposit Accounts
There are plenty of bank accounts one can choose from. These days, banks provide an array of accounts to meet the different needs of people from all walks of life like those managing household finances, business men and women, and large and small organizations.
Checking accounts provide safety and ease of use. Just like the name suggests, a checking account allows you to issue checks against the balance held in your account.
You can write a check for transferring funds across accounts or paying a bill. With this type of account, you can access your money anytime through an Automatic Teller Machine (ATM).
Most checking accounts come with cash debit cards. A debit card may be used to buy goods and services at any merchant outlet that is honored by your bank. The money to cover your purchases is deducted directly from your checking account. Using a debit card is similar to writing a check.
There are many advantages of a checking account, particularly if your check book is stolen or lost; you simply need to inform the bank to close your account and open a new account. This prevents anybody from misusing your old checks. Debit cards are useful if you are not comfortable with carrying around and managing your checks.
It is easy to keep track of your expenses with this type of account as the bank sends a monthly record of the checks issued by you. This record proves useful to cross-check your payments. Since a checking account is functional, it is suitable for meeting everyday expenses and not for saving purposes. As check processing is expensive, banks often charge a fee for utilizing this type of an account. Depending upon your requirements, you can choose from a variety of checking accounts including basic or student, or a joint account if you and your spouse both share the household expenses. An interest bearing checking account is good if you are able to meet the minimum balance requirements that usually go along with this type of account. Senior/student checking accounts offer many benefits such as better interest rates, free usage of ATMs, travelers checks, and regular checks.
Savings accounts hold your money safely while returning interest to you. This type of account can be used even to save small amounts of money. In fact, you can open a savings account with as little as $50. You can usually withdraw your money easily.
Through a savings account, you can teach children to save small amounts of money. This will help them learn good money management skills for the future.
Money Market Accounts
Money market accounts offer higher returns as compared to most savings accounts. This account is a step closer to investment and also enjoys the benefit of FDIC coverage of up to $250,000 per account. Money market accounts are best for maintaining your emergency cushion equal to 3-6 months of your salary. However, with a money market account you may have to maintain higher minimum balances like $500 to $1500, and they limit the number of withdrawals and checks you can write every month. If you exceed the limit, you may have to pay additional charges.
Certificates of Deposit (CD)
Certificates of Deposit (CD) are savings deposits that require you to keep a fixed amount of cash for a specified fixed period (example: depositing an amount of $2000 for 2 years). CDs have a higher rate of interest as compared to other accounts like checking, savings and money market accounts. A long term CD will ensure higher returns as your interest is compounded and credited to your account periodically. A short term CD may give you smaller returns but it will let you access your funds earlier. These higher interest bearing accounts are the safest investment vehicle since they have coverage from FDIC to safeguard your money. However, CDs have some liquidity restrictions and if you withdraw before the maturity date of your deposit, you may have to pay a penalty.
Individual Retirement Accounts (IRAs)
Tax-deferred accounts providing savings deposits for your retirement benefits are called Individual Retirement Accounts (IRAs). The more you invest in IRAs the more benefits you will receive in your later years. Although you do not pay any taxes on the money you deposit in your IRA until the time you withdraw, you may have to pay a significant penalty if you withdraw funds before your retirement age (59 years and above).
Now that you have learned all about how a bank works and the different types of ways to grow your money, you must learn to use a check register and reconcile your account to keep track of your expenses.
Using a Check Register
A check register is a written record of all your transactions in your checking account. Using this check register is a very important way to track activity in your checking account. When you open a checking account with a bank, you receive a check register that has rows and columns for filling in the date of checks issued, description of the transaction, amount of the transactions and your total balance at the outset.
Along with filling the details of your account transactions, ensure that you also note down the check numbers that you have issued in your checkbook. Update the account balance columns on your checkbook to help you track your balance so that you can spend accordingly.
Reconciling Your Account With Check Register
It is imperative that you reconcile your account every month. The transaction records that you have maintained in your check register must match with the bank records. This will ensure that there is no discrepancy in your accounts and help you maintain accurate balances.
Maintain Your Bank Account
It is important to properly maintain your bank accounts. Keep track of all your deposits, fund transfers and withdrawals by using the check register and reconcile your account at regular intervals. This will help you avoid negative consequences such as:
- Overdraft: Your account goes into overdraft if your withdrawals exceed the available balance in your account. This results in a negative account balance attracting high interest or fees charged by the bank due to a check bouncing.
- Bad checks: A bad check refers to a check that is not cleared because the amount on your check exceeds the balance in your account. A bad check is also known as NSF (Non- Sufficient Funds) or a rubber check. If you write a bad check, the recipients of the check or your bank may report your activities to ChexSystems or may take criminal or civil legal action against you depending on the laws applicable in the state where the check is written.
- ChexSystems: This is a database that keeps records on people who have mismanaged their bank account. If your checks bounce or if the bank closes your account for negative balances or if you have given the bank false information while opening the account, the bank will report this to the ChexSystems. ChexSystems is similar to your credit report (consisting of your credit history) and maintains a record of all your banking activities for a period of 5 years. This database is usually accessed by all banking institutions before they open your bank account. Some banks will not let you open an account with them if the ChexSystems has any negative information on you. Subsequently, all or any one of these activities may also lead to account closure. Therefore be alert and use a check register accurately. This will help you manage your personal finances more efficiently and maintain sufficient balances in your accounts.
In This Chapter You Learned:
- What a bank is and what it can do for you.
- The significance of putting your money in a bank
- How the bank operates to earn profits on your money for you as well as itself.
- The things to look for when choosing a bank.
- Different types of accounts to suit your individual banking needs.
- The importance of check registers and reconciling your account to maintain accurate balances.