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FIN 200: Personal Finance
Topic 4-Banking and Interest Rates Lawrence Schrenk, Instructor
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Learning Objectives
1. Discuss the types and services of financial institutions.
2. Reconcile a bank statement.
3. Distinguish risk-free rate, risk premium and loan rates.
4. Explain the term structure and yield curve
5. Calculate the interest rate and time in a compounding or discounting problem. ▪
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Depository and Non-Depository Institutions Depository institutions
Commercial Banks Contrast with Investment Banks (Glass-Steagall)
Savings Institutions Credit Unions
nonprofit, member-owned cooperatives
Non-Depository Institutions Finance Companies (Sub-Prime Crisis NYT article) Insurance Companies Securities Firms Investment Companies
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Services Convenience Services (Safeguard Valuables):
Checking Account Bank/Debit Cards
Distinguish from Credit Cards Safety Deposit Boxes ATMs Physical Instruments:
Cashier’s Checks Money Orders Traveler's Checks
Trade-Off: Fees versus Convenience
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Checking Account Types and Fees
Student accounts are often free Flat-Fee, No-Frills Account Free Banking: Non-Interest Paying
Minimum balance required (average $83) Free Banking: Interest Paying
Minimum balance required (average $3,300) Low Interest rates are usually low
Overdrafts (under Bank/Debit Cards)
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Reconciling a Checking Account Procedure to make sure you and your bank agree about your
monthly transactions by comparing beginning and ending balance plus individual transactions.
Beginning Balance+ Deposits- Withdrawals Cleared Checks Debit Transactions ATM Transactions Counter Transactions Automatic Withdrawals
- Bank Fees= Ending Balance- Uncleared Checks= Adjusted Balance
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Reconciling a Checking Account II
The distinction between checks, debits and withdrawals is vague.
Bank balance versus adjusted balance Don’t assume you can spend all your bank balance
Timing Issues The ’Float’ Clearing
Use software such as Money or Quicken.
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Debit Cards Bank/Debit Cards are NOT credit cards; they
draw funds from your bank account–You are not borrowing most of the time.
Processed as ‘debit’ You need to use a PIN number Sellers will try to get you to use this method
They can avoid the charges of credit card clearing Some banks may charge a fee
Processed as ‘credit’ No PIN required Usually no bank charge
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Debit Card as Credit Card No Overdraft: Bank declines payment. Courtesy Overdraft: ‘Courtesy’ of honoring
withdrawals with insufficient cash in your account.
A significant fee, e.g., $30-40 per overdraft. They may ‘arrange’ your overdrafts so you pay as many
individual fees as possible. You can be subject to late fees or interest.
Overdraft Protection: Overdrafts paid by credit card.
Obviously, this is like use a credit card for a normal purchase.
The charges are typically less than a courtesy overdraft.
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Automatic Teller Machines (ATMs)
Convenient Consider the extent of your bank’s network Average fee just above $3.00
Fees up 30% in three years Probably free through your bank’s system Probable double charges elsewhere Banks without networks may reimburse you
for fees
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Bank Cashier’s Checks, Money Orders, and Traveler's Checks Money Orders*
< $100.00 Specific Payee and Amount
Cashier’s Checks > $100.00 Specific Payee and Amount
Traveler’s Checks Standardized Values ($10, $20, $50,...)
Backed by bank (not your personal account) Fees (if any) are the key.
* ‘Money Orders’ can also refer to checks issued by a non-financial institution, e.g., the Post Office.
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Internet Financial Security Most financial Institutions have secure web sites Don’t include sensitive information in an e-mail, e.g.,
social security or credit card information. If via e-mail, anyone asks for personal information,
passwords, etc. Don’t send it. Use the official web site.
Watch for 'phishing' scams A web site that looks legitimate. But is a scam to get account
information, passwords, etc. Your web browser may warn you of suspected sites Be suspicious.
Here are some safety tips.
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Internet Banking
Convenient Brokerages or regular banks May offer higher interest on checking May refund ATM fees Examples: E*Trade, Fidelity Reputation and Security Traditional banks offer many of their services
online
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Institution Selection Factors Is your bank insured?
Does it display the FIDC Logo? Are your accounts there insured?
$100,000 per bank ($200,000 for joint account) $250,000 some retirement accounts FDIC's Electronic Deposit Insurance Estimator (EDIE)
Is your bank financial sound? Check it at HSH.
Is it convenient? Are the interest rate favorable and fees low?
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Interest Rates and the Term Structure
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Calculating Returns
You investment of $200.00 grows to $250.00. Dollar Return
New Value – Old Value = $250.00 - $200.00 = $50.00
Percentage Return/Holding Period Return (HPR)
In finance, return normally means percentage return.
25%200.00
200.00250.00
ValueOld
ValueOld - New ValueReturn
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Rate Types Risk-Free Rate, Rf
Usually this is the return on a federal government security
Risky Rate, R This rate includes additional compensation for risk
Risk Premium, RP RP = R – Rf, or R = RP + Rf
This measures additional compensation for risk Recall the discussion of the time value of
money.
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Term Structure versus Yield Curve
The Term Structure of Interest Rates: The relationship between annual yield of risk-free government securities and their maturity (their ’life’, e.g., a 10 year bond versus a 20 year bond). Jargon: We use the term ‘yield’ to refer to the
return on a bond, such as a government security. The ‘Yield Curve’ is the line that plots the
annual yield versus the maturity
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The Current Yield Curve
–Bloomberg
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Back to Math: Calculating Interest Rates and Time
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Interest Rates and Time
The following is the pattern for a compounding or discounting problem: The PV compounds to (is discounted from) the FV at
I/Y in N years. There are four variables: PV, FV, I/Y and N. Given any three of the variables, you can
calculate the fourth. We have done PV and FV, so we now cover I/Y
and N.
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An Interest Rate Problem
Problem: I want to buy a $30,000 car in 4 years. If I have $20,000 today, what interest rate do I need? What is I/Y?
Formula
There is a mathematical way to solve this equation for I/Y, but we’ll just use the financial calculator!
1 /N
FV PV I Y
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Interest Rates with a Calculator
Problem: I want to buy a $30,000 car in 4 years. If I have $20,000 today, what interest rate do I need? What is I/Y?1. Input 4, Press N
2. Input 20000, Press PV
3. Input 30000, Press +/-, press FV (-30,000)
4. Press CPT, I/Y to get 10.67, i.e., 10.67%
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Interest Rates with a Calculator0 1 2 3 4
??? ??? ??? ???
$20,000 $30,000
4 10.67 20000 -30000
Remember to press CPT, before I/Y (if necessary).
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An Time Problem
Problem: I want to buy a $30,000 car. If I have $20,000 today and can get an interest rate of 12%, how long must I wait? What is N?
Formula
There is a mathematical way to solve this equation for N, but again we’ll just use the financial calculator!
1 /N
FV PV I Y
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Time with a Calculator Problem: I want to buy a $30,000 car. If I
have $20,000 today and can get an interest rate of 12%, how long must I wait? What is N?1. Input 12, Press I/Y2. Input 20000, Press PV3. Input 30000, Press +/-, press FV (-30,000)4. Press CPT, N to get 3.58, i.e., 3.58 years 5. Since 12 × .58 = 6.96 ≈ 7, 3 years 7 months.NOTE: In time problems you should round to
months, but not the exact number of days.
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Time with a Calculator0 1 2 3 ???
12% 12% 12% 12%
$20,000 $30,000
3.58 12 20000 -30000
Remember to press CPT, before N (if necessary).
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Practice Problems
I have $30.00 in an account in which I put $25.00 6 years ago. What is the interest rate?
3.09% My account grew from $50,000 to $75,000 with an
interest rate of 10%. How long did it take? 4.25 years = 4 years 3 months
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Ethical Dilemma (Chap. 5, 141,8) Mike opened a checking account asking numerous
questions about checking and credit card fees. When Mike returns from an international trip, fees are on his statements. The bank informs him that they recently added international service charges and that his last statement had a flyer detailing these changes. Mike realizes he had received the information, but had ignored it because it was included with considerable advertising information and the lengthy document was in very small print. a. Comment on the ethics of banks and other financial
institutions' efforts to notify customers of fee changes. Should a letter be sent specifically dealing with these changes to ensure that customers are aware of the information?
b. Is there a lesson to be learned from Mike’s experience?
