Managing Liquidity

Planning Your Financial Future, 4eby: Boone, Kurtz & Hearth

Managing Liquidity

Chapter 4

2

The Roles of Money Management and Savings

If you can’t manage your checking and savings accounts properly, you’ll have trouble managing more complicated investments, such as retirement accounts

Why maintain cash balances? It’s expensive (because you’re forgoing

interest income) But we like the convenience

3


Why savings are so important Very liquid Serves as an emergency fund Allows us to achieve a certain goal

(vacation, car down payment, etc.) Americans save less than 2% of their

income Europeans save about 10%+

4


How much savings do you need? Emergency fund

Should have amount equal to about 3 to 6 months of after-tax income

Additional amount depends on your goals (short- and long-term) Do you want to buy a house soon? Need to save for

the down paymentHave money automatically transferred to

your savings account from each paycheck Treat it as a fixed expense

5


How fast your savings will grow depends upon: What interest rate your savings earn

(stated or nominal rate) Frequency of compounding How much money you deposit

periodically How your account balance is determined

6

What Determines How Fast Your Savings Will Grow?

The impact of time on interest earned If interest is being compounded (earning interest on interest),

time can have a significant impact The frequency of compounding

The more frequently money is compounded, the more often interest is paid—so money grows faster

Your effective interest rate is greater the more often interest is compounded

The treatment of deposits and withdrawals Most financial institutions use the day-of-deposit-to-day-of-

withdrawal method of computing interest Interest is based on the exact number of days the money is in your

account Other methods include minimum balance (will earn less interest

this way)

7

Figure 4.1: The Relationship Between Time and Interest Earned

Note: The example is based on a $1,000 deposit into an account earning 5 percent interest per year.

Source: Based on data from the Statistical Abstract of the United States, FDIC, Federal Reserve and Financial Services Statistics (Insurance Information Institute).

8

Figure 4.2: Simple and Compound Interest

Note: The example is based on a $1,000 deposit into an account earning 5 percent interest per year.

Source: Based on data from the Statistical Abstract of the United States, FDIC, Federal Reserve and Financial Services Statistics (Insurance Information Institute).

9

Choosing a Financial Institution

Financial institutions include banks and credit unions

Factors influencing your decision How important is convenience to you?

Do you choose a bank just because it’s right around the corner from your house?

Convenience is important, but nowadays with electronic banking it’s not as important

Direct deposit, online banking, ePay, etc.

10


What services do you expect? Electronic banking Safe-deposit box Do you want good, personal service where

the tellers know you by name?What insurance safeguards are present?

Most financial institutions (banks, credit unions) are federally insured up to $100,000

11


How much does it cost? Before deregulation financial institutions offered many services for

‘free’ Charged a basic fee for having an account Provided free checks, help with reconciliation, etc. Banks competed on the basis of service because basically all banks paid

customers same interest rate on deposits The spread between interest paid to customers and interest charged on

loans was large Since deregulation banks compete for deposits based on interest

rates Spread on interest paid vs. charged has narrowed Banks have eliminated ‘free’ services and now charge fees (sometimes

very HIGH fees) Banks collect about $20 billion in fees (up 200% from 10 years ago)

Fees vary widely from bank to bank Shop around

12

Types of Financial Institutions

Commercial banks (AKA full-service banks) Offer various services including

Checking and savings accounts Personal and business loans Trust services Safe-deposit boxes Mortgage loans Discount brokerage serves (maybe)

Convenient

13


Savings banks (S&Ls) Traditionally serve consumers Mortgage loans (make about 40% of all mortgage loans) Today are more similar to commercial banks

Credit unions Cooperative venture owned by depositors and borrowers Organized to serve specific groups of people Nonprofit – offer lower interest rates on loans, pay higher

interest rates on deposits Generally don’t want to take a great deal of risk

14


Brokerage firms Offer central asset management accounts

Combines a checking account, debit/credit card, and a money market fund with a traditional brokerage account

Cash earned from dividends, interest, etc. is automatically swept into a money market account

You start earning interest on your money immediately You can write a check (or use debit/credit card) to access

your funds Minimum investment required, which varies across

brokerage firms Check out minimum investment amount and fees (if any),

customer service, choice of money market funds, credit/debit card features, margin rates

15

Checking Accounts

Regular checking accounts Some banks require a minimum balance (average is

$500), which give you unlimited check writing privileges Some banks charge no fee unless you exceed a certain

number of checks per month Banks can pay interest on checking accounts but rarely do

Special checking accounts Require no minimum balance Most banks charge a per check fee ($0.10–$0.15 per

check) plus monthly maintenance fee May be a good choice for people who write very few checks a

month

16

Checking Accounts

Overdraft protection If you write a check for an amount greater than the balance

in your checking account, it is still covered You pay a fee (essentially interest on a short-term loan)

NOW accounts (negotiable order of withdrawal) Combined checking and savings account

Pays interest on balance (but lower rate than savings account) Can write checks (actually are authorizations to take money

from savings) Minimum balance of about $1,000

If balance drops below the minimum, a fee is charged Shop around!

NOW accounts at credit unions are called share-draft accounts

17

Consumer Loans

Car loansMortgage loansCollege loansHome improvement loansUnsecured personal loan

18

Bank Credit Cards

Allow consumers to purchase items in lieu of cash or check

Can also get a cash advanceEven pay your taxes

19

Other Banking Services

Retirement plans IRAs and Keoghs

Trustee services Estate planning and management

Safe-deposit boxes Fees vary (up to $100)

Bank wire transfers Send money to someone (quickly & long distances)

Debt management and counseling Often free

20

Electronic Banking

Electronic funds transfer system (EFTS) Paying bills, making withdrawals, or depositing

money electronically Quick, easy, cheap

ATMs, direct deposit, debit cards, etc. Online banking

Expected to experience rapid growth Convenient

Safety of EFTS Can be difficult to resolve problems due to lack of paper

records Can’t stop payment on check since transfer is

instantaneous

21

How to Write and Endorse a Check

Writing a check Get into habit of completing stub or register before

you write check Helps prevent you from forgetting the amount of the check

Endorsing a check Blank endorsement

Person to whom check was written signs name on back Is able to be cashed by anyone once endorsed

Restrictive endorsement Limits further negotiation of check Use when mailing a check to bank for deposit

Special endorsement Names a third party who can cash the check

22

Balancing Your Checkbook

Should reconcile checkbook every month when monthly statement is received

If you don’t contact the bank about a bank error within a specified time period, the bank may not correct its mistake

23

Balancing Your Checkbook

Steps involved Note the number of checks that cleared the bank Compare the dollar amount for each check to the

amount written on the check and check register Compare your record of deposits to the bank statement Compare your record of ATM and other EFTS

transactions to the bank statement Subtract any fees and add any interest Total all checks you’ve written and any ATM

withdrawals not on statement Subtract this amount from balance on statement

Total all deposits not yet processed and add to balance

24

Checks That Guarantee Payment

If you receive a check as payment, the check could bounce and you wouldn’t get the cash You may insist on a certified check

Guarantees paymentCashier’s check

Customer buys a check from bank’s general fund Bank won’t issue certified check until it’s paid for

Traveler’s checks Guaranteed by issuer

Used primarily by business and vacation travelers

25

Savings Accounts

Those offered by banks and credit unions are federally insured

Non-fixed time deposits Can add/withdraw money with basically no

restrictions at any time Passbook savings account

May require a minimum to open ($100 or less) Interest rate is low May charge a fee if balance drops below set amount or

number of transactions exceed a certain amount NOW account

Basically an interest-bearing checking account

26

Savings Options

Money Market Deposit Account (MMDA) Interest rate fluctuates with the market rate Initial deposit $1,000 Only a certain number of withdrawals are allowed per month

(penalty assessed if rules aren’t followed) Fixed-time deposits

Saver agrees to keep money in account for a certain time period (earn higher interest)

Certificate of Deposit (CD) Sacrifice liquidity If interest rates are rising, and you’ve locked in a long-term

CD, is it worth it to pay the interest penalty? Some banks offer variable rate CDs Shop around

27

Money Market Mutual Funds

Pool many investors’ funds and invest in short-term, low-risk investments

Not federally insured In practice, this risk is very small

Require a minimum initial deposit ($1,000)Can write checks (minimum amount of check

value is about $250) Some funds limit the number of checks you can

write each month

28

U.S. Treasury Bills and Notes

Issued by the U.S. government (very safe)Can be sold prior to maturity Interest income is not subject to state taxes

T-bills have 3, 6 and 12 months until maturity Minimum investment of $1,000 Interest is discounted

T-notes have 2, 3, 5, and 10 years to maturity Pay fixed amount of interest twice a year Face value is as low as $1,000

29

U.S. Savings Bonds

Face amounts range from $50 to $30,000 Can buy from financial institutions Purchase price is half the face value Bond will mature at some point (when exactly

depends on the interest rate) Interest accumulates (even after maturity) until 30

years after the issue date Exempt from state taxes Federal taxes are owed only when bond is cashed in or

reaches 30 years from issue date Series I bonds pay a fixed interest rate + the average

rate of inflation

30

Choosing the Best Savings Option

Need to evaluate Minimum investment Liquidity Yield Safety Taxation

Documents

Managing Liquidity