Friday, May 6, 2011

Introduction to Bank Accounts

Now that we've learned a lot about budgeting, where should you put your money?  Hopefully, you have decided to save at least 20% of your income (may be less depending on how large your income is and how much your needs take up), but where should you put those savings?  The most common place is the bank.

I don't think I have ever met someone who wasn't familiar with what a bank is, but there may be some of the smaller details you have never thought about.  So for those of you who are starting to become fully financially independent, a bank is probably one of the best places to store your money when you are not going to be using it in the near future.  There are two specific types of bank accounts: checking and savings.  A checking account is used for a lot of transactions (when you need to withdraw money from an ATM or write a check to pay your bills) and savings accounts are used to put away money for long periods of time so that you can earn interest.  Interest is essentially the bank paying you to leave their money with them and the main motivation for why you should save money: your money will be making money for you.  Also, with a checking account, you usually get a debit card and a checkbook with a set of free checks.

I will go over the nitty-gritty details about how to choose a bank and what features to look out for next time, but for now let's just talk about how commercial banks work.  The typical bank makes money by lending it out to people so it plays both the role of the borrower and the lender.  For people who need to take out a mortgage loan or any other type of loan, a bank assesses their credit risk and offers them the loan at a specified interest rate.  Where does the bank get this money?  There are a lot of technical details with how banks manage money with each other and the government, but essentially a lot of their holdings come from people like us who deposit our hard earned money into the bank.  Usually, loan interest rates are much higher than savings account interest rate because the bank earns money on this difference.  What determines interest rates?  That takes a couple economics courses worth of material that will probably put you to sleep, but in general it is determined by how much money is available in the economy which is determined by the government to some extent.

One important thing to note is that banks do not hold all the money they receive from us.  It was implied by the fact that banks lend out money but banks normally only have a percentage of our deposits in cash with them.  If we theoretically all went to the banks and demanded all the money in our accounts at once, the bank would be unable to give it to us because they don't have enough cash on hand to satisfy all the liabilities.  These circumstances have happened in the past, called bank runs, especially in times of crisis.  An important thing to look for when choosing a bank is to make sure that it is FDIC insured.  FDIC is the federal government agency that insures your account with the bank so that you will be guaranteed to get your money from the government if the bank ever fails.  The current insurance amount is $250,000 per depositor, per insured bank for each account ownership category, and most of the big banks are FDIC insured.  If your local bank is a little smaller, I would double-check to make sure that it is FDIC insured so that it will be one less worry on your mind.

One final thing to note about savings accounts is that there is a monthly limit on how many transfers you can make from the account.  The current limit is 6 outgoing transfers per month, and I don't believe it will change in the near future but it is possible it will change some time from now.  There is usually a fee charged if you go over this limit, but I usually just move the total sum of my credit card debt from my savings to a checking account in one transfer and then pay off each card separately.  Just keep in mind that with a savings account, there is a limit to how many times you can move money out of it (although not into it) while a checking account has no such restrictions.

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