|
The Purpose of Financial Institutions
“One of the most important roles of a bank is serving as intermediaries to transfer savings from some people to
others who need to borrow...A student just emerging from dental school seldom has enough cash on hand to buy all the equipment
and supplies needed to get started as a dentist. Almost no one has enough cash on hand to buy a house and many must buy a
car with installment payments.” --Thomas Sowell, “Basic Economics”
When I first read this in Sowell’s book, I absolutely loved how simply he defined the role of a bank. A bank truly
is there to basically be the “middle man” between those who want to save money and those who want to borrow money.
And they do this successfully by offering to pay interest to the people who save, and then charging a higher interest to those
who borrow. The difference between the two would be their revenue. Their revenue minus expenses (as is the case with all businesses)
is their profits. And if you have seen the size of the buildings that banks own and occupy, you know that there are plenty
of profits to be made.
People have different thoughts and feelings about banks. As in many things in life, the scale is everywhere from “absolutely
love” to “absolutely hate” and anywhere in between.
Those who love banks tend to have good histories and success working with banks throughout the years. They probably make
deposits regularly, have a loan or two that they pay on time, and may even have a little or lot saved up for a rainy day.
Those who hate banks, on the other hand, tend to have been wronged by them or seen firsthand a friend or family member
completely financially ruined by their dealings with banks. On a lesser scale, they may just hate banks because they used
to have an account but got sick of getting charged fees for everything from withdrawing money to even asking what their account
balance was.
And yet there are still those, typically those of the population who have more age experience than most, who remember
a time when banks actually deserved to be hated. A time when bankers would purposely deceive customers since the law wasn’t
very strict and it meant fatter paychecks for themselves. But times have definitely changed, and lending is slowly becoming
a “borrower’s market” so to speak. That is, the laws are getting better at protecting borrowers to make
sure that they are not being mistreated when it comes to borrowing money.
You will notice that the quote says “one of the most important roles of a bank,” not just the important role.
What other roles does the bank have? Well, one of the other important roles is to increase the money supply indirectly. Now,
don’t let that sentence confuse you: only the Federal Reserve can (legally) increase the money supply directly. So how
does a bank indirectly increase it? By the money multiplying concept known as the money multiplier.
Financial Institutions
Financial institutions (banks, savings and loans, credit unions, etc) all have one basic mission: collect money
from accountholders by offering them a certain interest rate, and then turn around and lend that money out at a higher interest
rate. The difference between the interest money that they earn (through loans and fees) and how much they pay out (to
those with interest earning savings/deposit accounts as well as basic expenses to keep the company running) is profit for
the company.
So what is the difference, then, between a bank, a savings and loan, and a credit union? Well...not much.
Click here to read about the differences.
As I mentioned, the goal of any financial institution (or any business, for that matter) is to be profitable. In
order to do that, they need to make sure that their income is greater than their expenses. The main way they do that
is by increasing the margin between the interest they pay out (to depository accounts) and the interest they earn (through
loans). The second most productive means to make a profit is to charge fees, and each institution has its own fee schedule.
Most charge for the common things such as returned check fees, wire transfers, etc. Some charge monthly or annual fees
on some of the accounts (deposit or lending products). And even some (of the not-so-nice banks) charge fees to speak
with a teller, check your balance over the phone, use the ATM machine, etc.
General Rules to Banking
There are a few general rules to banking that I have come up with so far. These can be used when determing whether
or not to open an account at a financial institution, although I'll use phrasing that will assume an account is already established.
I try to put the most important ones first, but these really are not in any particular order.
Become familiar with the financial institution's fee schedule. If you have an account that has a monthly/annual
fee, contact your financial institution and see if there is any way to waive that fee. If not, analyze your situation
and see if the benefits earned from that account justify the fee you pay for it. More often than not, a financial institution
will charge a monthly fee to use an account that really has no benefit to you; just a benefit to them (your money!).
Realize that there is no benefit to saving money at a 1% rate while also paying interest on a loan at a higher rate.
In this case, pay the loan off faster (assuming there is no pre-payment penalty). It makes no sense to earn money (which you have to pay taxes on at the end of the year, by the way) while paying
even more in interest on your loans. The only exception might be if your only debt was a home loan, whose interest may
be tax deductible. Even so, you would need to have a very good interest rate on your home loan (4 - 6% at most) for
the tax advantage to offset the interest paid vs. the interest earned.
I can't stress enough the importance of balancing your own account. I find it important enough that I even created
my own section solely dedicated to spreading that information: Do Me a Favor.
Loans
When it comes to loans, many people are shy, uncomfortable, or even slightly embarrassed when having to
borrow money from a financial institution. Why is that the case? Well, because they are asking for money. Think
about it: if you were going out to lunch with someone and you forgot your wallet (or just plain didn’t have any money
to begin with) then how do you feel having to ask your friend to “spot you” some money? Most of us feel bad
and uncomfortable doing so.
However, there are always times when people just simply have to borrow money. The most obvious and necessary example
would be a home purchase. Most people do not have $100,000 or $200,000 (or more) lying around in which to buy a house
in full. And for most of us, to save up that amount of money would take many years, or even a lifetime. I suppose
it is not too ironic then to tell you that many people spend their life paying off their home loan. It doesn’t
necessarily have to be that way, and I’ll explain that later when I mention paying off loans sooner. Click here if you’d like to read about paying off your loans faster.
Getting back to the point: loans. The word “loan” or “credit” is a bad word to many people. The
fact that they are borrowing money and have to pay back the money WITH interest, to them is a sin. With some interest
rates, this very well could be the case. However, lending money and being able to borrow money is really what makes our
economy function and rise. Most businesses in this country, just like houses, were created by using the money borrowed
from loans. Without the possibility to borrow money, many people would be stuck in the same dead end situation: not being
able to move out of their apartment (or, even their parents' house for that matter), not being able to get out of their job,
not being able to test to see if their new idea could be the next best thing since sliced bread.
On the flip side, there are some people who have absolutely no issues with the term “loan” or “credit”
or “debt.” They don’t think of it in terms of “I need to borrow this to get ahead in life”
but more along the lines of “I can’t live without this good/service.” In case you didn’t guess,
the “necessity” they “can’t live without” is usually things like jewelry, nice cars, a big house,
or expensive clothes. So, yeah, the “needs” they have are really just “wants” that are
usually quenched by excessive amounts of debt.
So what exactly does debt cost? Most people think of it in terms of percentage rates. “$10,000 in debt
at 15%.” But what does this mean? Obviously it means it is worse than $10,000 in debt at 10% and better than
$10,000 in debt at 20%.
Others think of debt in monthly terms. Instead of thinking they have $10,000 of debt at 15%, they think of their
debt as $300/month. If they get a good raise at work, then they will see their monthly income increase and will then
find something else they can afford on a monthly basis.
When you think of debt, however, I ask you - no I beg you! - to think of it on a daily basis. And not just "how much
is my minimum monthly payment divided by 30?" No - think of it as your daily cost. $10,000 of debt at 15%
means you are paying $4.11 of interest per day. At 10% it would cost you $2.74 per day. At 20%, you’d pay
$5.48 per day. But what does this mean? It means that EVERY day your balance stays at $10,000 (at 15%) you will
pay $4.11 of interest. You can think of it as a $4.11/day fee if you'd like, since that's technically what it is.
Even if you paid off the $10,000 the day after you borrowed the money, you'd still have to pay $4.11 - so yes, it's very much
like a fee. Financial institutions will just call it "interest" so that is sounds a little nicer than "fee."
This $4.11/day is what is most commonly referred to as “per diem” or a daily finance charge. Although
it is most commonly mentioned for installment loans (such as a car loan or personal loan), it still rings true for all loans. Per
diem, in essence, tells you exactly how much you pay every day just for having the debts you have. Call it a blessing
or (most likely) a curse; but it is what it is. It is debt. And it is expensive.
You may say at this point: well $5 per day isn’t that much to pay. Well, if we use the example of $10,000 at
20%, consider that your $10,000 loan costs you $164 per month - it sounds a little worse doesn’t it? The
average monthly payment on your card will probably be 2 – 3% of the balance due (so about $200 to $300 per month). Let’s
just assume 3% for this example. That means you would send in a check for $300 to pay your credit card bill for the month. Well,
the first $164 would go to interest, and only $136 would go towards paying down your debt. If we assume, also, that you
do not continue to use your credit card and focus just on paying it off, then that means at the end of the month your balance
will be $9,864 instead of $9,700 (had your entire payment gone towards principle). So, on the next month, you will pay
interest on $9,864 which amounts to $5.40 per day or $162 per month. Had all $300 gone towards the principle balance,
then the daily finance charge would be $5.32 which would amount to $159 per month. Another way to look at it is that
your full payment ($300) is paid on the loan (decreasing it to $9,700) but then the monthly interest due is charged to the
loan ($164) thus increasing the bill back up to $9,864. This, by the way, is usually how a credit card loan handles
the interest payment. An installment loan usually shaves the interest off of the payment first, then applies the remaineder
to principle. Either way, you end up paying interest on both your original debt (principle) and the interest charged
to it.
You might say to yourself, “$3 difference per month between both situations? Big deal!” Well, when
you consider that it will take you upwards of 20 years to pay off your credit card at this rate (again, assuming you do not
charge any more on the card), you are taking about several hundreds of dollars difference. Not to mention, your total
interest charges would be in the thousands itself.
"The most powerful force in the universe is compound interest." -- Albert Einstein
In the book E=mc2 David Bodanis writes about Einstein's development of "the world's most famous equation." The book describes in detail the process necessary for creating this equation. The equation itself shows the correlation
between the speed of light (c), energy (E), and mass (m). More specifically: an object's energy is equal to it's mass
times the square of the speed of light. The speed of light is approximately 300,000,000 meters/second. Or for
those of you not keen on the metric system: 670,000,000 miles/hour.
So, yes, the man who uncovers the truth about the universe's energy potential says that it isn't even as "great" as
compounding interest.
But the "greatness" of compounding interest depends on which financial end you are on. If you are trying to save
money, then you definitely will agree with Einstein. This may not be the case, however, if you are borrowing money and
come to realize that the bank is earning interest through compounding off of YOU! Either way, comounding is so
powerful because of the fact it compounds (either for the saver or the lender).
As I showed in the example above, if the interest on a loan was just “tacked onto the end” then the loan would
be paid off much quicker. But when people pay interest on their debt as well as the interest added to their debt (paying
$9,864 instead of $9,700) then they end up paying much more debt throughout the life of the loan. So, bottom line, your
goal should always be on the receiving end, not the paying end, of compounding interest.
What many people do not realize is that most loans do not have pre-payment penalties. If you are applying for a
loan currently that mentions a pre-payment penalty (and if you're not sure, be sure to ask the loan officer) then I would
strongly suggest steering away from that loan and find one that does not have a pre-payment penalty.
The same thing goes for annual fees or loan application fees. If you're applying for a loan and it claims the loan
will have these penalties/fees here is what I suggest:
1. See if what you will be paying for is worth it. If it's a large loan (i.e. home mortgage) than you most
likely won't be able to avoid all of these fees (although an annual fee should never pertain to an installment loan).
Ask yourself: "What am I getting for my money?" Are you just getting a loan, or does it come with other benefits such
as airline miles/valuable points (i.e. credit cards) or a lower interest rate? If not, definitely read #2.
2. Can you get the same loan somewhere else for less/free or without pre-payment penalties? Don't just assume
in this case. There are TONS of financial institutions battling for your business. Go with your gut feelings:
if you have checked around and what you're offered seems good (but not too good to be true) then go with it. If you
think you might be able to beat the price/fees, you probably can.
What if there is a pre-payment penalty? Well, it's not the end of the world. But it is worth it to calculate
two things: how much interest would you pay if you continue to pay as you have to avoid pre-payment penalties, and how much
would the pre-payment penalty cost? If the penalty is less than what you would otherwise pay in interest, and assuming
you can afford to do so, pay off the loan sooner.
This goes back to the savings interest vs. credit interest mentioned earlier. How much sense does it make to earn
1% interest in a savings account while paying 12% interest on your credit card? Likewise, how much sense does it make
to spend another $1000 in interest rather than pay the loan off sooner and pay a $500 pre-payment penalty.
Ok, so you've checked your loan and you've found that there is no pre-payment penalty. What is the best way to
save money while paying off your loan? Well, the obvious yet highly overlooked answer is to pay more than the minimum
due on it. Every loan you have (or at least the ones legally obtained) will require a minimum payment each month.
Depending on the type of loan, it may be the same amount each month (installment loans) or it might fluctuate depending on
your remaining balance (lines of credit). Bottom line: the financial institution wants a portion of the loan repaid
each month. And millions of Americans pay just the minimum each month, whether it's their credit cards, their car
loans, or their mortgages. Let's take a look at what paying the minimum really costs, versus paying a little extra.
Here's an Example...
Say you're looking for a $100,000 mortgage on a 30 year fixed rate. For this example we will use 6.375% as the
rate. On the first example I will show you how much you end up paying if you pay just the minimum payment every month
(for 30 years) and how much time/money is saved if you pay just $100 extra each month.*
Paying the minimum:
| Pmt |
Principal |
Interest |
Cum Prin |
Cum Int |
Prin Bal |
| 1 |
92.62 |
531.25 |
92.62 |
531.25 |
99907.38 |
| 2 |
93.11 |
530.76 |
185.73 |
1062.01 |
99814.27 |
| 3 |
93.61 |
530.26 |
279.34 |
1592.27 |
99720.66 |
| 4 |
94.10 |
529.77 |
373.44 |
2122.04 |
99626.56 |
| 5 |
94.60 |
529.27 |
468.04 |
2651.31 |
99531.96 |
| 6 |
95.11 |
528.76 |
563.15 |
3180.07 |
99436.85 |
| 7 |
95.61 |
528.26 |
658.76 |
3708.33 |
99341.24 |
| 8 |
96.12 |
527.75 |
754.88 |
4236.08 |
99245.12 |
| 9 |
96.63 |
527.24 |
851.51 |
4763.32 |
99148.49 |
| 10 |
97.14 |
526.73 |
948.65 |
5290.05 |
99051.35 |
| 11 |
97.66 |
526.21 |
1046.31 |
5816.26 |
98953.69 |
| 12 |
98.18 |
525.69 |
1144.49 |
6341.95 |
98855.51 |
| 349 |
585.44 |
38.43 |
93350.88 |
124379.75 |
6649.12 |
| 350 |
588.55 |
35.32 |
93939.43 |
124415.07 |
6060.57 |
| 351 |
591.67 |
32.20 |
94531.10 |
124447.27 |
5468.90 |
| 352 |
594.82 |
29.05 |
95125.92 |
124476.32 |
4874.08 |
| 353 |
597.98 |
25.89 |
95723.90 |
124502.21 |
4276.10 |
| 354 |
601.15 |
22.72 |
96325.05 |
124524.93 |
3674.95 |
| 355 |
604.35 |
19.52 |
96929.40 |
124544.45 |
3070.60 |
| 356 |
607.56 |
16.31 |
97536.96 |
124560.76 |
2463.04 |
| 357 |
610.79 |
13.08 |
98147.75 |
124573.84 |
1852.25 |
| 358 |
614.03 |
9.84 |
98761.78 |
124583.68 |
1238.22 |
| 359 |
617.29 |
6.58 |
99379.07 |
124590.26 |
620.93 |
| 360 |
620.93 |
3.30 |
100000.00 |
124593.56 |
0.00 |
Total Repaid: $224593.20
Total Interest Paid: $124593.20
Interest as percentage of Principal:
124.593%
Adding just $100 to each month's payment will pay the $100,000 loan off 110 months faster (250 months instead of 360).
Not only that, but you also save over $43,000 in interest in the long run.
| Pmt |
Principal |
Interest |
Cum Prin |
Cum Int |
Prin Bal |
| 1 |
192.43 |
531.25 |
192.43 |
531.25 |
99807.57 |
| 2 |
193.45 |
530.23 |
385.88 |
1061.48 |
99614.12 |
| 3 |
194.48 |
529.20 |
580.36 |
1590.68 |
99419.64 |
| 4 |
195.51 |
528.17 |
775.87 |
2118.85 |
99224.13 |
| 5 |
196.55 |
527.13 |
972.42 |
2645.98 |
99027.58 |
| 6 |
197.60 |
526.08 |
1170.02 |
3172.06 |
98829.98 |
| 7 |
198.65 |
525.03 |
1368.67 |
3697.09 |
98631.33 |
| 8 |
199.70 |
523.98 |
1568.37 |
4221.07 |
98431.63 |
| 9 |
200.76 |
522.92 |
1769.13 |
4743.99 |
98230.87 |
| 10 |
201.83 |
521.85 |
1970.96 |
5265.84 |
98029.04 |
| 11 |
202.90 |
520.78 |
2173.86 |
5786.62 |
97826.14 |
| 12 |
203.98 |
519.70 |
2377.84 |
6306.32 |
97622.16 |
| 241 |
686.33 |
37.35 |
93655.61 |
80751.27 |
6344.39 |
| 242 |
689.98 |
33.70 |
94345.59 |
80784.97 |
5654.41 |
| 243 |
693.64 |
30.04 |
95039.23 |
80815.01 |
4960.77 |
| 244 |
697.33 |
26.35 |
95736.56 |
80841.36 |
4263.44 |
| 245 |
701.03 |
22.65 |
96437.59 |
80864.01 |
3562.41 |
| 246 |
704.75 |
18.93 |
97142.34 |
80882.94 |
2857.66 |
| 247 |
708.50 |
15.18 |
97850.84 |
80898.12 |
2149.16 |
| 248 |
712.26 |
11.42 |
98563.10 |
80909.54 |
1436.90 |
| 249 |
716.05 |
7.63 |
99279.15 |
80917.17 |
720.85 |
| 250 |
720.85 |
3.83 |
100000.00 |
80921.00 |
-0.00 |
Total Repaid: $180920.00
Total Interest Paid: $80920.00
Interest as percentage of Principal:
80.920%
Here is a list of the most common types of services that financial institutions offer. Not all institutions offer
these, and those that do may charge a fee, so please check with your institution to clarify.
Wire Transfer
A wire transfer ("wire") is an electronic transfer of funds from one financial institution to another.
There are two types: domestic and foreign wires. Domestic wires refer to those which are initiated and received
at financial institutions within the United States. Foreign wires, as you may have guessed, involved a transfer of funds
from/to a financial institution outside of the United States.
Domestic wires are the most common type of wire initiated. The fee for such a wire is usually between $15 and $30.
Some institutions also charge for incoming wires (wires that you receive into your account, as opposed to wires that you send
from your account). Be sure to check with your financial institution before initiating or receiving a wire to see what
the fees are.
**Note** The only financial institution I have heard of that offers free outgoing wire transfers is Washington
Mutual. The great news is that the free outgoing wires comes with their WaMu Free Checking account. It just requires
a minimum of $1 to open and has no minimum balance requirements or monthly charges. This account is new as of March,
2006 so prior to that, all accounts I've ever heard of required a fee for sending a wire transfer. Also note: the incoming
wire to the same WaMu Free Checking account does hold a fee: $10 for incoming domestic wires; $15 for incoming foreign wires.
Check around, cause many credit unions, and possibly some banks, may accept incoming wires without a fee.
Contrary to popular belief, however, wire transfers are not instantaneous. When a wire is initiated at
your bank, it has to go from your bank's accounting department (or wire department if they have one) to the Federal Reserve.
Facts and figures are confirmed and then the wire is sent from the Federal Reserve to the receiving bank's accounting/wire
department. The whole process generally takes a couple of hours; sometimes more, sometimes less.
Foreign wires are an even greater beast. The initiating bank's accounting/wire department forwards the funds
onto the Federal Reserve which then forwards it on to the proper foreign bank/institution. How long does it take?
Well, in order for the initiating bank to even inquire about the status of the foreign wire, 2 weeks have to
pass. So, if you're looking for an instantaneous funds transfer overseas, I suggest using Western Union or the like.
These can generally be done within a matter of minutes or hours, but, of course, comes with a higher fee.
Cash Advance
A cash advance is an advancement of funds from your available credit line on your credit card. For example: if
you have a credit card with a $5,000 cash advance credit limit available, you can take your card (and proper ID) to any financial
institution that is eligible to perform cash advances** and you can get $5,000 cash from the institution. The $5,000
you borrow will then, of course, show up as a cash advance on your credit card, and you are now responsible for paying those
funds back just as if you were to go on a $5,000 shopping spree at a local retail store.
There are a couple of catches, of course. Many credit cards have a seperate "cash advance rate" that
is at a higher interest rate than for normal purchases. This makes sense, if you think of it from the bank's point of
view: they are allowing you the convenience and freedom of getting $5,000 cash to do whatever you'd like with it.
So even if your interest rate on regular purchases is 12.99%, for a cash advance it may be 18.99%.
The other catch is the "grace period." See, on a normal credit card purchase, you usually have a set number of
days (20 - 30 typically) in which you may hold the debt before any interest is charged. Pay it off in time, you pay
no interest. Pay late, and interest (and usually a late charge) is then applied. This is not the case, however,
if you get a cash advance OR if you have an outstanding purchases balance (you didn't pay off your credit card bill in total
last month). When there is no "grace period" that means you pay interest on the loans every day until they're paid off,
as mentioned above.
* In all of these examples, keep in mind that the figures are estimates. Although this
gives one a good idea as to how much a loan payment would be, how long it would take to pay a loan off, how much interest
would be charged through the life of the loan, etc. it is important to keep in mind that these are just estimates. Many
factors, especially the exact day in which the loan payment is made, can alter the results.
For example: these figures all assume payments are made on the same exact day of the month
and that there are equal # of days between each payment. Paying a loan payment a few days before or after these estimated
dates could add or subtract a marginal amount of interest. See my explanation of interest for more information.
**Not all financial institutions offer cash advancement services since it does cost them to
be able to offer it. Even if they do offer it, this does not guarantee that they can accomodate for each credit card
issuer (Visa, Mastercard, Discover, American Express, etc.) since it costs them for each issuer they sponsor. The credit
union I used to work for only paid to sponsor Visa; the bank I used to work for sponsored all 4 listed above.
But, once the institution sponsors one of the issuers, it must accomodate to all customers of that particular company.
So, for instance, if the bank only allows cash advances on Visas, then anyone with a Visa card could go to that bank,
whether they have an account or not, and get a cash advance.
|
