We talked about Saving in our last Financial Literacy Month Post, but banking involves more than just savings accounts.
Banks earn money by providing services to paying customers. That might include loans (mortgage, auto, business and personal loans), as well as bank accounts of various types, and products like CDs and safe deposit boxes.
Your bank pools all of the funds deposited with it by people like you, and uses that money to offer loans. With some kinds of savings accounts you even share some of the profit the bank earns. Your bank might offer a mortgage loan at 4.5%, and give you 1% interest on your savings account. Checking accounts usually carry a modest monthly fee, but the bank may waive that fee under certain circumstances (like if you have direct deposit of your paycheck into the account). You don’t typically earn interest on the checking account.
Most banks are insured by the FDIC (Federal Deposit Insurance Corporation), so you know your money is safe. Without a bank, you might keep all of your money in the form of cash or real property, but it will be subject to theft, disaster, or other losses.
There are other ways to store wealth other than bank accounts, but banks are the most convenient option. The quickest way to access your money, other than keeping it in your pocket, is to have it in a bank account.
Different kinds of banks
Credit Unions are a special kind of bank run as a non-profit organization. They typically are open only to people who are eligible for membership—a credit union historically might have served the employees of a particular company, members of a specific church, or residents of a local community. These days credit unions are open to more than just limited applicants.
A credit union typically offers better interest rates than banks, and given their small, local nature, it’s possible to form a relationship over time with your credit union. The downside to credit unions is typically convenience. They will have limited locations and limited banking hours. So while credit unions offer a lot of advantages over banks, your money will be less accessible.
Savings & Loan associations were designed to help moderate-income people grow their savings and borrow money for things like homeownership. They served people who typically could not get service from traditional banks.
Commercial Banks typically serve businesses, giving corporations a place to deposit funds or obtain business loans & lines of credit.
These days the lines between the different kinds of banks are more blurry. One can typically get most of the traditional banking products & services from just about any kind of bank.
Types of Bank accounts
- Savings Accounts, keep your money safe and earn a small amount of interest. The funds are available to be withdrawn whenever you need them.
- Checking accounts let you transfer funds to other by writing checks or using a debit card linked to the account. Bank accounts typically carry a small monthly fee, but that may be waived under the right conditions. In some very rare cases, a checking account might actually earn interest.
- Money Market accounts usually require a minimum balance to stay open—often a few thousand dollars is needed. The accounts earn a much her interest rate than traditional savings, but the money is less accessible, and you have to be wary of dropping below the minimum balance and triggering penalty fees.
- CDs (Certificates of Deposit) require you to keep your money untouched for a set period of time. The longer you agree to leave the money alone, the more interest it will earn.
For example, a bank might offer traditional savings at 1% or less. If you agree to leave your money in a CD for one year, that deposit might earn 1.3%. If you buy a 3-year CD, it might earn 1.6%. And if you commit to a 5-year CD, you could get an interest rate of 2% (these are just examples—real rates will vary).
If these sample rates seem low—they are. Like we said in our inflation post, this kind of interest has you losing wealth, since the value of your dollars is dropping faster than interest is accruing. This is a result of keeping interest rates extremely low. The Federal Reserve lowers rates to spur economic activity. When borrowing gets easy due to low rates, more people take out loans for businesses, mortgages and new car purchases. This added economic activity comes at the expense of saving for the long term. It also creates more debt, which is a problem that will eventually need to be faced.
Fractional Reserve Banking
For part of the US’s history, currency was on the “gold standard” which meant money was backed by precious metals. For a bank to issue a dollar bill, they had to have a dollar’s worth of gold in storage. You may even see old dollar bills that say “Silver Certificate” instead of “Federal Reserve Note” at the top. These bills were redeemable for their value in silver.
For the past 40 years or so, the US has used a fiat money system, which establishes money through government action, rather than backing the currency’s value with precious metals. Because the government can now print money as needed without needing gold on hand, inflation is a greater risk. On the plus side, economists say that fiat money means the Fed can create currency as needed to help stave off recessions or avoid a repeat of the Great Depression.
Fractional reserve banking means that banks don’t actually need to have as much money on hand as they loan out. Under a gold standard, every depositor could go down to the bank at once, withdraw their money in gold, and there would be enough to satisfy the demand. Under fractional reserve banking, the bank might have a very small amount of funds on hand, and if too many people tried to withdraw their money at once, there wouldn’t be enough for everyone.
This is called a run on the bank. If depositors become afraid that they won’t be able to get to their money, they might all simultaneously try to close their accounts. This can cause banks to become insolvent.
This is why the FDIC was created. This guarantees your money is safe, so as long as you bank with an FDIC insured institution, you don’t need to rush down to the bank and pull your money when you see signs of a bank run. The standard limit for coverage is $250,000 per depositor. So if you are lucky enough to have more than $250,000 on hand, you’ll want to establish accounts at different banks to stay under the insured limit.
Banks have other kinds of private insurance to cover losses from events like robbery or natural disasters.
Choosing a bank
It’s often tempting to go with the cheapest option you can find for banking. Or the branch closest to you. Or the bank that offers the best interest rates. The truth is, all of these considerations must be balanced.
A bank that offers services for free or at a very low rate usually will require a high minimum balance, and you’ll have to be sure you can maintain that high minimum in the event of an emergency.
The bank closest to you is typically going to be a branch from a large banking chain that has locations on every corner. These banks are much more likely to impose high fees, or set traps that make it easy for you to trigger penalties.
We suggest prioritizing safety first. By safety, we mean, is the bank FDIC insured, and is it safe for you to do business with them without falling prey to a lot of predatory fees?
Second to safety is expense. Does the bank pay a competitive interest rate on deposit accounts, and will it waive checking fees if you use direct deposit? How are its ATM fees?
Third should be convenience. It’s nice to have a bank nearby with accessible business hours. But we’ve learned in over 40 hears of working to help people obtain debt relief that having your money too easily accessible can lead to problems. For many people, we like the idea of making one’s money harder to reach in a credit union with few locations and limited hours. That way every withdrawal will have to be considered and planned for, and not impulsive.
Other considerations might include whether the financial institution is a good neighbor. How does it comply with the community reinvestment act? How does it treat its employees? If a financial institution has a good reputation for charitably works, that might be a good sign that they will treat their customers better than another bank.