Managing Your Liquidity

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1 2P A R T Managing Your Liquidity Chapter 5 Banking and Interest Rates What bank services are most important to you? Which financial institution will provide the best bank services for you? Chapter 6 Managing Your Money Can you pay anticipated bills on time? How can you maintain adequate liquidity to cover anticipated expenses? How can you invest your remaining money among money market investments? Your Financial Plan for Managing Liquidity Your Wealth Chapter 7 Managing Your Credit Are you eligible to receive credit? What limit should you impose on credit? When should you use credit? T H E C H A P T E R S I N T H I S P A R T explain the key decisions you can make to ensure adequate liquidity. Chapter 5 describes how to select a financial institution for your banking needs. Chapter 6 details how you can manage your money to prepare for future expenses. Chapter 7 explains how you can access credit as an additional source of liquidity. Your selection of a financial institution, money management, and credit management will influence your liquidity and therefore affect your cash flows and wealth.

2 Banking and Interest Rates C H A P T E R 5 needed a few dollars for some item or another. Thinking that this was nothing out of the ordinary, she continued this pattern for the first month of school. When Lisa arrived on campus for her first year of college, she did not open a checking account locally because she already had one in her hometown. She knew that she could always use an Automated Teller Machine (ATM) to obtain cash for the many little necessities of college life (food, movies, video rentals, and more food). For the first month she frequently visited an ATM; nearly every other day she It was only on a weekend trip back home, where she reviewed her latest bank statement, that Lisa became aware of a problem. Her bank statement showed 34 separate charges for ATM fees. She had been charged $1.00 for each trip to an out-of-network ATM not owned by her bank. There was another $1.50 fee charged by the bank that owned the ATM, so each ATM visit created two charges. In addition, Lisa discovered that she had made five balance inquiries on out-of-network ATMs and her bank charged $0.50 for each of them. Altogether, for her 17 visits to the ATM, Lisa had accrued $42.50 in ATM fees and $2.50 in inquiry fees for a total of $ Shocked at this discovery, Lisa sought out and found a bank that had a branch on campus and several ATM locations that were convenient for her to use. 125

3 126 B A N K I N G A N D I N T E R E S T R A T E S A good bank is an essential ingredient to the liquidity of your financial plan, whether you are depositing funds in an interest-earning account or are in need of a loan. You may choose a commercial bank, a credit union, or an online bank. In each case it is important to know how well your money is secured. You should also be interested in knowing how the bank sets its interest rates on your deposits and on any loan you might take out. Interest rates fluctuate frequently and are dependent upon several factors, as you will find out in Appendix 5A at the end of this chapter. The objectives of this chapter are to: describe the functions of financial institutions, identify the components of interest rates, and clarify the relationship between the maturity and interest rate of an investment. TYPES OF FINANCIAL INSTITUTIONS Individuals rely on financial institutions when they wish to invest or borrow funds. In this chapter we ll examine the two major types of financial institutions, depository institutions and nondepository institutions. depository institutions Financial institutions that accept deposits (which are insured up to a maximum level) from individuals and provide loans. commercial banks Financial institutions that accept deposits and use the funds to provide commercial (business) and personal loans. DEPOSITORY INSTITUTIONS Depository institutions are financial institutions that offer traditional checking and savings accounts for individuals or firms and also provide loans. They pay interest on savings deposits and charge interest on loans. The interest rate charged on loans exceeds the interest rate paid on deposits. The institutions use the difference to cover expenses and to provide some earnings for their stockholders. Depository institutions are skilled in assessing the ability of prospective borrowers to repay loans. This is a critical part of their business, since the interest from loans is a key source of their revenue. There are three types of depository institutions: commercial banks, savings institutions, and credit unions. Commercial Banks. Commercial banks are financial institutions that accept deposits in checking and savings accounts and use the funds to provide commercial (business) and personal loans. The checking accounts normally do not pay interest. The savings accounts pay interest, while certain other accounts pay interest and can be used to write checks. These accounts are described in more detail in the next chapter. Deposits at commercial banks are insured up to $100,000 per depositor by the Federal Deposit Insurance Corporation (FDIC), a government-owned insurance agency that ensures the safety of bank deposits. You can look to a commercial bank to provide a personal loan for the purchase of a car or other big-ticket items. They also offer mortgage loans for pur-

4 TYPES OF FINANCIAL INSTITUTIONS 127 chasing a home. Some commercial banks own other types of financial institutions (such as those described next) that provide additional services to individuals. savings institutions (or thrift institutions) Financial institutions that accept deposits and provide mortgage and personal loans to individuals. credit unions Nonprofit depository institutions that serve members who have a common affiliation (such as the same employer or the same community). Savings Institutions. Savings institutions (also referred to as thrift institutions) accept deposits and provide mortgage and personal loans to individuals. They differ from commercial banks in that they tend to focus less on providing commercial loans. They typically offer the same types of checking and savings deposits as banks, and these deposits are also insured up to $100,000 per depositor by the FDIC. Credit Unions. Credit unions are nonprofit depository institutions that serve members who have a common affiliation (such as the same employer or the same community). Credit unions have been created to serve the employees of specific hospitals, universities, and even some corporations. They offer their members deposit accounts that are similar to the accounts offered by commercial banks and savings institutions; the accounts are insured by the National Credit Union Share Insurance Fund (NCUSIF) for up to $100,000 per member. Credit unions also provide mortgage and personal loans to their members. FOCUS ON ETHICS: SPECIAL RATES ON DEPOSITS As mentioned earlier, depository institutions pay interest on savings deposits. Some institutions have catchy advertisements stating that they will pay a higher annual interest on new deposits than other depository institutions. Are these offers a sure thing? Probably not. Before making any deposit, you need to check the fine print and ask important questions. How long is the rate for? If it is for a short term, what will it be lowered to? How long must you maintain the deposit before you can withdraw your funds? Usually the fine print in newspaper or Internet offers indicates that the rate will be lowered after the first month. The deposit is risky if it is not insured, and the rate may be lower than other banks deposit rates after the first month. Either of these conditions could cause the return on this deposit to be less than that offered by other depository institutions. Carefully research advertised offers. nondepository institutions Financial institutions that do not offer federally insured deposit accounts, but provide various other financial services. finance companies Nondepository institutions that specialize in providing personal loans to individuals. NONDEPOSITORY INSTITUTIONS Nondepository institutions are financial institutions that provide various financial services, but their deposits are not federally insured. The main types of nondepository institutions that serve individuals are finance companies, securities firms, insurance companies, and investment companies. Finance Companies. Finance companies specialize in providing personal loans to individuals. These loans may be used for various purposes such as purchasing a car or other products or adding a room to a home. Finance companies tend to charge relatively high rates on loans because they lend to individuals who they perceive to have a higher risk of defaulting on the loans. When the economy weakens, borrowers may have more difficulty repaying loans, causing finance companies to be subject to even higher levels of loan defaults.

5 128 B A N K I N G A N D I N T E R E S T R A T E S securities firms Nondepository institutions that facilitate the purchase or sale of securities by firms or individuals by providing investment banking services and brokerage services. insurance companies Nondepository institutions that provide insurance to protect individuals or firms against possible adverse events. investment companies Nondepository institutions that sell shares to individuals and use the proceeds to invest in securities to create mutual funds. financial conglomerates Financial institutions that offer a diverse set of financial services to individuals or firms. Securities Firms. Securities firms facilitate the purchase or sale of securities (such as stocks or bonds) by firms or individuals by offering investment banking services and brokerage services. Investment banking services include: (1) placing securities that are issued by firms, meaning that the securities firm finds investors who wish to purchase those securities; (2) advising firms regarding the sale of securities, which involves determining the price at which the securities may be sold and the quantity of securities that should be sold; and (3) advising firms that are considering mergers about the valuation of a firm, the potential benefits of being acquired or of acquiring another firm, and the financing necessary for the merger to occur. In addition to offering investment banking services, securities firms also provide brokerage services, which facilitate the trading of existing securities. That is, the firms execute trades of securities for their customers. One customer may desire to sell a specific stock while another may want to buy that stock. Brokerage firms make a market for stocks and bonds by matching up willing buyers and sellers. Insurance Companies. Insurance companies sell insurance to protect individuals or firms. Specifically, life insurance companies provide insurance in the event of a person s death. Property and casualty companies provide insurance against damage to property, including automobiles and homes. Health insurance companies insure against specific types of health care costs. Insurance serves a crucial function for individuals because it compensates them (or their beneficiaries) in the event of adverse conditions that could otherwise ruin their financial situation. Chapters discuss insurance options in detail. Investment Companies. Investment companies use money provided by individuals to invest in securities to create mutual funds. The minimum amount an individual can invest in a mutual fund is typically between $500 and $3,000. Since the investment company pools the money it receives from individuals and invests in a portfolio of securities, an individual who invests in a mutual fund is part owner of that portfolio. Thus, mutual funds provide a means by which investors with a small amount of money can invest in a portfolio of securities. More than 6,000 mutual funds are available to individual investors. More details on mutual funds are provided in Chapter 17. FINANCIAL CONGLOMERATES Financial conglomerates offer a diverse set of financial services to individuals or firms. Examples of financial conglomerates include Citigroup, Bank of America, and Merrill Lynch. In addition to accepting deposits and providing personal loans, a financial conglomerate may also offer credit cards. It may have a brokerage subsidiary that can execute stock transactions for individuals. It may also have an insurance subsidiary that offers insurance services. It may even have an investment company subsidiary that offers mutual funds containing stocks or bonds. Exhibit 5.1 shows the types of services offered by a typical financial conglomerate. By offering all types of financial services, the financial

6 BANKING SERVICES OFFERED BY FINANCIAL INSTITUTIONS 129 Exhibit 5.1 How a Financial Conglomerate Serves Individuals FINANCIAL CONGLOMERATE Bank Subsidiary Accepts Deposits Provides Personal Loans Offers Credit Cards Securities Subsidiary Provides Brokerage Services Offers Mutual Funds Insurance Subsidiary Provides Insurance Services conglomerate aims to serve as a one-stop shop where individuals can conduct all of their financial services. BANKING SERVICES OFFERED BY FINANCIAL INSTITUTIONS A depository institution may offer you a wide variety of banking services. While a nondepository institution does not offer banking services, it may own a subsidiary that can provide banking services. Some of the more important banking services offered to individuals are described here. CHECKING SERVICES You use a checking account to draw on funds by writing checks against your account. Most individuals maintain a checking account so that they do not have to carry much cash when making purchases. In addition, it is safer to mail payments by check than by cash. To illustrate how your checking account works, assume that you pay a phone bill of $60 to your phone company today. The phone company provides the check to the bank where it has an account. The bank electronically increases the phone company s account balance by $60. At the same time, the bank reduces your account balance by $60 if your checking account is at that bank, or electronically signals to the bank where your account is to reduce your balance by $60. Monitoring Your Account Balance. As you write checks, you should record them in your checkbook so that you can always determine how much money is in your account. By keeping track of your account balance, you can make sure that you stay within your limit when writing checks. This is very important, because you are charged fees when you write a check that bounces. In addition, you might lose some credibility when writing bad checks, even if it is unintentional.

7 130 B A N K I N G A N D I N T E R E S T R A T E S EXAMPLE Reconciling Your Account Balance. Financial institutions normally send a checking account statement once a month. When you receive your bank statement, you should make sure that the statement reconciles (agrees) with your record of transactions in your check register. Mark off on your register the checks that the statement indicates have cleared. The account balance changes from one month to another for three reasons: depositing or withdrawing funds from your account, cleared checks, and monthly fees related to the checking account. Last month, the balance in your checking account was $600. This month you deposited $100 to your account. You wrote four checks that cleared, totaling $400. You did not withdraw any funds from your account. There were no fees charged this month. Your balance for this month is: Last month s balance $600 Deposits $100 Checks that cleared $400 New balance $300 In a month in which you had no fees, no deposits, and no withdrawals, and did not deposit funds, the balance from the statement should be the same as the balance on your register as long as all checks that you wrote cleared. But if some checks have not yet cleared, the balance on your statement will exceed the balance on your register by the dollar amount of the checks that have not yet cleared. If you write additional checks, you may have a negative balance once all the checks clear. For this reason, you should not rely on the monthly statement to determine your balance. EXAMPLE Your most recent checking account statement shows that you have a balance of $300. However, yesterday you wrote checks totaling $250 to pay bills. When these checks clear, your balance will be $50. Today you received a credit card bill for $200. Even though this amount is less than the balance shown on your most recent statement, you do not have sufficient funds in your checking account to pay this bill. If you write a check to cover the credit card bill, it will bounce, because you really only have a $50 account balance. By using the register to keep track of the checks that you write, you will know the amount of funds available in your account. Many banks provide a worksheet that can be used to reconcile your checkbook balance with the bank s statement of your account. An example of a reconciliation worksheet is shown in Exhibit 5.2. Based on the cleared checks, deposits, and withdrawals, the balance on your bank statement should be $500. This balance can be compared to the balance shown on the bank statement. If

8 BANKING SERVICES OFFERED BY FINANCIAL INSTITUTIONS 131 Exhibit 5.2 Example of a Worksheet to Reconcile Your Bank Statement Beginning Balance $1,000 Deposits $100 $400 $500 $500 Withdrawals $50 $150 $200 $200 Checks that have cleared $25 $75 $700 $800 $800 Bank Fees $0 $0 Balance Shown on Bank Statement $500 Checks that have not yet cleared $100 $60 $40 $200 $200 Adjusted Bank Balance (your prevailing bank balance) $300 there is a discrepancy, your balance may be wrong or the bank s statement could be incorrect. The first step is to verify your math in your checkbook register and then double-check the math on the reconciliation worksheet. If you still cannot resolve the discrepancy, contact the bank. Accessing Your Account Balance. You can verify your checking account balance with many financial institutions by calling an automated phone service or by going to the institution s Web site and logging in with a password. However, you should not use this balance to determine your spending limit, as some checks you wrote may not yet have cleared. Electronic Checking. An electronic checking system will someday make the check clearing process much more efficient. It is already being used to a limited degree. When you write a check to a retail store for a purchase, the funds are electronically transferred from your account to the retail store s account. The cashier at the store stamps the back of the check, gives it back to you, and the check clears immediately. This system reduces fraud because the payee knows if there are sufficient funds in the customer s account to make a purchase. If there were not enough

9 132 B A N K I N G A N D I N T E R E S T R A T E S funds, the electronic transfer would not occur, and the check writer could not make the purchase. Reducing fraud saves the retail stores money and makes them more willing to accept checks. debit card A card that is used to make purchases that are charged against a checking account. safety deposit box A box at a financial institution where a customer can store valuable documents, certificates, jewelry, or other items. automated teller machines (ATMs) Machines where individuals can deposit and withdraw funds any time of the day. CREDIT CARD FINANCING Individuals use credit cards to purchase products and services on credit. At the end of each billing cycle, you receive a bill for the credit you used over that period. MasterCard and Visa credit cards allow you to finance your purchases through various financial institutions. Thus, if you are able to pay only the minimum balance on your card, the financial institution will finance the outstanding balance and charge interest for the credit that it provides to you. DEBIT CARDS You can use a debit card to make purchases that are charged against an existing checking account. If you use a debit card to pay $100 for a car repair, your checking account balance is reduced by $100. Thus, using a debit card has the same result as writing a check from your checking account. Many financial institutions offer debit cards for individuals who find using a debit card more convenient than carrying their checkbook with them. In addition, some merchants will accept a debit card but not a check because they are concerned that the check may bounce. A debit card differs from a credit card in that it does not provide credit. With a debit card, individuals cannot spend more than they have in their checking account. SAFETY DEPOSIT BOXES Many financial institutions offer access to a safety deposit box, where a customer can store valuable documents, certificates, jewelry, or other items. Customers are charged an annual fee for access to a safety deposit box. AUTOMATED TELLER MACHINES (ATMS) Bank customers are likely to deposit and withdraw funds at an automated teller machine (ATM) by using their ATM card and entering their personal identification number (PIN). Located in numerous convenient locations, these machines allow customers access to their funds 24 hours a day, any day of the year. Some financial institutions have ATMs throughout the United States and in foreign countries. You can usually use ATMs from financial institutions other than your own, but you may be charged a service fee, such as $1 per transaction.

10 SELECTING A FINANCIAL INSTITUTION 133 cashier s check A check that is written on behalf of a person to a specific payee and will be charged against a financial institution s account. CASHIER S CHECKS A cashier s check is a check that is written on behalf of a person to a specific payee and will be charged against a financial institution s account. It is especially useful when the payee is concerned that a personal check may bounce. EXAMPLE You wish to buy a used car for $2,000 from Rod Simpkins, who is concerned that you may not have sufficient funds in your account. So you go to Lakeside Bank, where you have your checking account. You overcome Rod s concern by obtaining a cashier s check from Lakeside Bank made out to Rod Simpkins. After verifying your account balance, the bank complies with your request and reduces your checking account balance by $2,000. It will likely charge you a small fee such as $10 or $15 for this service. Rod accepts the cashier s check from you because he knows that this check is backed by Lakeside Bank and will not bounce. money order A check that is written on behalf of a person and will be charged against an account. traveler s check A check that is written on behalf of an individual and will be charged against a large well-known financial institution or credit card sponsor s account. MONEY ORDERS A money order is a check that is written on behalf of a person and will be charged against an account. The U.S. Post Office and some financial institutions provide this service for a fee. They are a better alternative to cash when you need to mail funds. TRAVELER S CHECKS A traveler s check is a check that is written on behalf of an individual and will be charged against a large well-known financial institution or credit card sponsor s account. It is similar to a cashier s check, except that no payee is designated on the check. Traveler s checks are accepted around the world. If they are lost or stolen, the issuer will usually replace them without charge. The fee for a traveler s check varies among financial institutions. SELECTING A FINANCIAL INSTITUTION Your choice of a financial institution should be based on convenience, deposit rates and deposit insurance, and fees. Convenience. You should be able to deposit and withdraw funds easily, which means the financial institution should be located close to where you live or work. You may also benefit if it has ATMs in convenient locations. In addition, a financial institution should offer most or all of the services you might need. Many financial institutions offer Internet banking, which allows you to keep track of your deposit accounts and even apply for loans online. Many financial institutions also allow online bill paying. On the Web site, you indicate the payee and amount and the financial institution elec-

11 134 B A N K I N G A N D I N T E R E S T R A T E S 5.1 Financial Planning Online: Internet Banking Go to: /consumer_information/ what_you_should_know_ about_internet_banking.cfm This Web site provides: information that can help you decide whether an Internet bank suits your needs. tronically transfers the funds. There is usually a small fee for this service, but the fee is probably less than the cost of a stamp if you mail the bill yourself. Some Web-based financial institutions do not have physical branches. For example, NetBank ( is a Web-based bank. While Web-based banks allow you to keep track of your deposits online, they might not be appropriate for customers who prefer to deposit funds directly at a branch. For customers who prefer to make deposits at a branch but also want easy online access to their account information, the most convenient financial institutions are those with multiple branches and online access. Deposit Rates and Insurance. The interest rates offered on deposits vary among financial institutions. You should comparison shop by checking the rates on the types of deposits that you might make. Financial institutions also vary on the minimum required balance. A lower minimum balance on savings accounts is preferable because it gives you more flexibility if you do not want to tie up your funds. Make sure that any deposits are insured by the FDIC or NCUSIF. Web-based financial institutions tend to pay a higher interest rate on deposits than institutions with physical branches, because they have lower expenses and can afford to pay higher deposit rates. Customers must weigh the tradeoff of the higher deposit rates against the lack of access to branches.

12 INTEREST RATES ON DEPOSITS AND LOANS Financial Planning Online: Financial Institutions That Can Serve Your Needs Go to: business_ and_economy/ finance_and_ investment/ banking/ This Web site provides: information about individual financial institutions (including Internet banks), such as the services they offer and the interest rates they pay on deposits or charge on loans. Customers who prefer to make deposits through the mail may want to capitalize on the higher rates at Web-based financial institutions. Fees. Many financial institutions charge fees for various services. Determine any fees for writing checks or using ATMs. Avoid financial institutions that charge high fees on services you will use frequently, even if the institutions offer relatively high rates on deposits. certificate of deposit (CD) An instrument that is issued by a depository institution and specifies a minimum investment, an interest rate, and a maturity. INTEREST RATES ON DEPOSITS AND LOANS So far, this chapter has focused on financial institutions and their services, such as accepting deposits and providing loans. The return you receive from your deposits in a financial institution and the cost of borrowing money from a financial institution are dependent on the interest rates. Therefore, your cash inflows and outflows are affected by the interest rates at the time of your transactions with the institution. Most depository institutions issue certificates of deposit (CDs), which specify a minimum investment, an interest rate, and a maturity. For example, a bank may require a $500 minimum investment on all the CDs it offers. The maturities may include one month, three months, six months, one year, and five years. The money invested in a particular CD cannot be withdrawn until the maturity date, or it will be subject to a penalty for early withdrawal.

13 136 B A N K I N G A N D I N T E R E S T R A T E S The interest rate offered varies among maturities. Interest rates on CDs are commonly stated on an annualized basis so that they can be compared among deposits. An annual interest rate of 6 percent on your deposit means that at the end of one year, you will receive interest equal to 6 percent of the amount that you originally deposited. risk-free rate A return on an investment that is guaranteed for a specified period. risk premium An additional return beyond the risk-free rate that can be earned from a deposit guaranteed by the government. RISK-FREE RATE A risk-free rate is a return on an investment that is guaranteed for a specified period. As an example, at a commercial bank you can invest in a CD with a maturity that matches your desired investment horizon. When you invest in a CD that has a maturity of one year, you are guaranteed the interest rate offered on that CD. Even if the bank goes bankrupt, the CD is insured up to $100,000 per account by the federal government, so you will receive your deposit back at the time of maturity. RISK PREMIUM Rather than investing in risk-free deposits that are backed by the federal government, you could invest in deposits of some financial firms that offer a higher interest rate. These deposits are sometimes called certificates, but should not be confused with the CDs that are backed by government insurance. These certificates are subject to default risk, meaning that you may receive a lower return than you expected if the firm goes bankrupt. If you have accumulated only a small amount of savings, you should maintain all of your savings in a financial institution where deposits are guaranteed by the government. It is not worthwhile to strive for a higher return because you could lose a portion or all of your savings. If you have a substantial amount of money, however, you may consider investing a portion of it in riskier deposits or certificates, but you should expect to be compensated for the risk. Your potential return should contain a risk premium, or an additional return beyond the risk-free rate that you could earn from a deposit guaranteed by the government. The higher the potential default risk of an investment, the higher the risk premium that you should expect. If a particular risky deposit is supposed to offer a specific return (R) over a period and you know the risk-free rate (R f ) offered on a deposit backed by the government, you can determine the risk premium (RP) offered on the risky deposit: RP R R f EXAMPLE Today, your local commercial bank is offering a one-year CD with an interest rate of 6 percent, so the existing one-year risk-free rate is 6 percent. You notice that Metallica Financial Company offers an interest rate of 10 percent on one-year certificates. The risk premium offered by this certificate is:

14 INTEREST RATES ON DEPOSITS AND LOANS Financial Planning Online: Current Interest Rate Quotations Go to: /markets/rates/index.html This Web site provides: updated quotations on key interest rates and charts showing recent movements in these rates. It also illustrates how bank deposit rates and loan rates have changed over time. RP R R f 10% 6% 4%. You need to decide whether receiving the extra 4 percentage points in the annual return is worth the default risk. As you have a moderate amount of savings accumulated, you determine that the risk is not worth taking. LOAN RATE Financial institutions obtain many of their funds by accepting deposits from individuals. They use the money to provide loans to other individuals and firms. In this way, by depositing funds, investors provide credit to financial markets. Financial institutions must charge a higher interest rate on the loans than they pay on the deposits so that they can have sufficient funds to pay their other expenses and earn a profit. Therefore, to borrow funds, you normally must pay a higher interest rate on the loan than the prevailing rate offered on deposits. The annual interest rate on loans to individuals is often 3 to 7 percentage points above the annual rate offered on deposits. For example, if the prevailing annual interest rate on various deposits is 6 percent, the prevailing annual interest rate on loans to individuals may be 9 to 13 percent. Exhibit 5.3 shows the relationship between the one-year CD rate and the average one-year rate on loans to individuals. Notice how the loan rate rises when the financial institutions must pay a higher rate of interest on the CDs that

15 138 B A N K I N G A N D I N T E R E S T R A T E S Exhibit 5.3 Impact of Deposit Rates on Loan Rates Estimated One-Year One-Year CD Rate Loan Rate for Individuals % 11% % 10.5% % 8% % 7.5% % 8% % 10% % 9.5% % 9.3% % 9.2% % 9% % 10.5% % 8% % 8.5% Annual Yield (%) Time to Maturity (Years) they offer. In some periods, there is a general shortage of funds, and interest rates are higher (see the chapter appendix). If the CD rate paid by financial institutions increases, they normally raise their loan rate to maintain the premium that they earn above the deposit rate that they pay. The interest rate a financial institution charges for a loan often varies among individuals. Higher rates of interest are charged on loans that are exposed to

16 INTEREST RATES ON DEPOSITS AND LOANS 139 higher default risk. So, individuals with poor credit histories or low incomes will likely be charged higher interest rates. IMPACT OF CHANGES IN INTEREST RATES As time passes, the general level of interest rates changes (as explained in detail in the chapter appendix). When interest rates rise, individuals who make deposits will earn a higher rate of interest, while individuals who need to borrow funds will have to pay a higher rate. You can find the current levels of interest rates on the Internet (see Financial Planning Online 5.3). COMPARING INTEREST RATES AND RISK When considering investments that have different degrees of risk, your choice depends on your risk tolerance. If you plan to use all of your invested funds for necessities one year from now, you may need to avoid risk completely. In this case, you should choose a risk-free investment because other investments could be worth less in one year than they are worth today. The tradeoff is that you will receive a relatively low rate of interest on your investment. If you will need only a portion of your initial investment at the time the investment matures, you may be willing to take some risk. In this case, you may prefer an investment that offers a higher interest rate than the risk-free rate, but is exposed to the possibility of a loss. You can afford to take some risk, since you would still have sufficient funds to pay for your necessities even if the investment results in a loss. However, you should still consider a risky investment only if the risk premium on the investment compensates you for the risk. No single choice is optimal for all investors, as the proper choice varies with the investor s situation and willingness to tolerate risk. Some individuals are more willing to accept risk than others. The investment decision is based on your risk tolerance, which in turn is influenced by your financial situation. EXAMPLE Stephanie Spratt plans to invest $2,000. She will use these funds in one year as part of a down payment if she purchases a home. She is considering the following alternatives for investing the $2,000 over the next year: 1. A bank CD that offers a return of 6 percent (the risk-free rate) over the next year and is backed by government insurance. 2. An investment in a deposit at a financial firm that offers an interest rate of 9 percent this year but is not backed by a government guarantee. Stephanie evaluates her possible investments. The 6 percent return from investing in the CD would result in an accumulated amount of: Accumulated Amount Initial Investment (1 Return) $2,000 (1.06) $2,120.

17 140 B A N K I N G A N D I N T E R E S T R A T E S The accumulated amount if Stephanie invests in the risky deposit is: Accumulated Amount Initial Investment (1 Return) $2,000 (1.09) $2,180. Comparing the two accumulated amounts, Stephanie sees that she would earn an extra $60 from the risky deposit if the firm performs well over the next year. There is a risk that the return from the risky deposit could be poorer, however. If the risky deposit pays her only what she originally invested, she would earn zero interest. If the firm goes bankrupt, it might not have any funds at all to pay her. Although the chances that this firm will go bankrupt are low, Stephanie decides that the possibility of losing her entire investment is not worth the extra $60 in interest. She decides to invest in the bank CD. term structure of interest rates The relationship between the maturities of risk-free debt securities and the annualized yields offered on those securities. TERM STRUCTURE OF INTEREST RATES When considering investing in bank deposits or other debt securities, you must first determine your timeline for investing. When investors provide credit to financial markets, the relationship between the maturity of an investment and the interest rate on the investment is referred to as the term structure of interest rates. The term structure is often based on rates of return (or yields) offered by Treasury securities (which are debt securities issued by the U.S. Treasury) with different maturities. The rates of CDs and Treasury securities with a specific maturity are very similar at a given point in time, so this term structure looks very similar to one for deposit rates of financial institutions. The term structure is important to investors and borrowers because it provides the risk-free interest rates that you could earn for various maturities. EXAMPLE You are considering depositing $500 in a financial institution. You do not expect to need the funds for at least three years. You want to assess the term structure of interest rates so that you know the interest rate quoted for each maturity. The institution s rates as of today are shown in Exhibit 5.4. The relationship between the maturities and annualized yields in Exhibit 5.4 is graphed in Exhibit 5.5. The term structure shown here for one specific point in time illustrates that annualized interest rates are higher on investments with longer terms to maturity. Thus, the longer the investment horizon you choose, the higher the annualized interest rate you receive. You should not invest in a deposit that has a longer term to maturity than the three years in which you will need the funds because you will be subject to a penalty if you withdraw the funds before that date.

18 TERM STRUCTURE OF INTEREST RATES 141 Exhibit 5.4 Annualized Deposit Rates Offered on Deposits with Various Maturities Maturity Annualized Deposit Rate (%) 1 month months months year years years years years years 6.0 Exhibit 5.5 Comparison of Interest Rates among Maturities Annual Yield (%) Time to Maturity (Years) SHIFTS IN THE YIELD CURVE The yield curve derived from annualized Treasury security yields appears every day in the Wall Street Journal, as shown in Exhibit 5.6. The current day s yield curve is compared to the curve from one week ago and four weeks ago. This allows you to easily see how the returns from investing in debt securities with different maturities have changed over time.

19 142 B A N K I N G A N D I N T E R E S T R A T E S 5.4 Financial Planning Online: Updated Treasury Yields Go to: /markets/rates/index.html This Web site provides: yields of Treasury securities with various maturities. This information is useful for determining how your return from investing funds in Treasury securities or bank deposits could vary with the maturity you choose. Exhibit 5.6 Treasury Security Yields Yields as of 4:30 p.m. Eastern time (%) Yesterday 1 week ago 4 weeks ago mos. maturities HOW BANKING SERVICES FIT WITHIN YOUR FINANCIAL PLAN The key banking decisions for your financial plan are: 1. What banking service characteristics are most important to you? 2. What financial institution provides the best banking service characteristics for you? Interest rates will play a role in your decisions because you can compare rates among financial institutions to determine where you would earn the high-

20 HOW BANKING SERVICES FIT WITHIN YOUR FINANCIAL PLAN 143 est return on your deposits or pay the lowest rate on your loans. By making informed banking decisions, you can ensure that you receive the banking services that you need to conduct your financial transactions and have the convenience and fees that you desire. As an example, Exhibit 5.7 shows how banking service decisions apply to Stephanie Spratt s financial plan. Exhibit 5.7 How Banking Services Fit within Stephanie Spratt s Financial Plan Goals for Banking Services 1. Identify the most important banking services. 2. Determine which financial institution will provide me with the best banking services. Analysis Characteristic How It Affects Me Interest rate offered on deposits This will affect the amount of interest income I earn on deposits. Interest rate charged on mortgages Interest rate charged on personal loans Fees charged for checking services Location Online services available ATMs I could use the same financial institution if I buy a home in the future. I could use the same financial institution if I obtain a personal loan in the future. I will be writing many checks, so fees are important. The ideal financial institution would have a branch near my apartment building and near where I work. This would make my banking more convenient. Check locations for convenience and whether any fees are charged for using ATMs. Decisions Decision regarding Important Characteristics of a Financial Institution: My most important banking service is the checking account because I will write many checks every month. I prefer a bank that does not charge fees for check writing. I also value convenience, which I measure by the location of the financial institution s branches, and its online services. I would prefer a financial institution that offers reasonable rates on its deposit accounts, but convenience is more important to me than the deposit rate. Decision regarding the Optimal Financial Institution: After screening financial institutions according to my criteria, I found three financial institutions that are desirable. I selected Quality Savings, Inc., because it does not charge for check writing, has branches in convenient locations, and offers online banking. It also pays relatively high interest rates on its deposits and charges relatively low interest rates (compared to other financial institutions) on its loans. I may consider obtaining a mortgage there someday if I buy a home, as its mortgage rate was comparable to those of other financial institutions.

21 144 B A N K I N G A N D I N T E R E S T R A T E S DISCUSSION QUESTIONS 1. How would Stephanie s banking service decisions be different if she were a single mother of two children? 2. How would Stephanie s banking service decisions be affected if she were 35 years old? If she were 50 years old? SUMMARY Depository institutions (commercial banks, savings institutions, and credit unions) accept deposits and provide loans. Nondepository institutions include insurance companies (which provide insurance), securities firms (which provide brokerage and other services), and investment companies (which offer mutual funds). Financial conglomerates offer a wide variety of these financial services so that individuals can obtain all their financial services from a single firm. An interest rate is composed of the risk-free rate and the risk premium. The risk-free rate is the rate of interest paid on an investment that has no risk over a specific investment period (such as a bank deposit backed by government insurance). Risky investments offer a return that exceeds the riskfree rate. The risk premium is the additional amount above the risk-free rate that risky investments offer. The higher an investment s risk, the higher the risk premium it must offer to entice investors. The term structure of interest rates is the relationship between interest rates and maturities. It is measured by the yield curve, which shows the interest rate offered at each maturity level. The yield curve is typically upward sloping, meaning that the annualized interest rate is higher for debt securities with longer terms to maturity. INTEGRATING THE KEY CONCEPTS Your selection of a financial institution is important for various parts of your financial plan. A financial institution can serve your liquidity needs (Part 2) by offering a source for your deposits. In addition, a financial institution may also satisfy your financing needs (Part 3) by providing a personal loan or a mortgage loan so that you can purchase a car or a home. A financial institution may have an insurance subsidiary that can provide you with insurance services (Part 4). It may be able to advise you on your investments (Part 5) or even sell you the types of investments that you desire. It may also be able to offer you a retirement account (Part 6). 6. Retirement and Estate Planning (Retirement Planning, Estate Planning) 5. Investing (Stocks, Bonds, Mutual Funds) 1. Financial Planning Tools (Budgeting, Time Value, Tax Planning) Your Selection of a Financial Institution 4. Protecting Your Assets and Income (Insurance) 2. Liquidity Management (Banking, Money Management, Credit Management) 3. Financing (Personal Loans, Mortgages)

22 A P P E N D I X Interest Rates: How They Are Determined and Why They Change 5A A change in the risk-free interest rate can greatly impact investor returns and the financing charges on borrowed funds. The following discussion provides a framework that not only enables you to understand why interest rates change, but also allows you to anticipate potential changes in interest rates, which may affect your investment and financing decisions. HOW THE RISK-FREE INTEREST RATE IS DETERMINED The risk-free interest rate on borrowed funds is determined by the total (or aggregate) supply of funds provided by all investors and the total (or aggregate) demand for funds by all borrowers. Imagine that there is a single commercial bank that accepts deposits from any investors who have funds that they wish to invest and channels the funds as loans to all borrowers who need funds. The interest rate on debt represents the cost of using debt (credit) for the borrower and the reward for providing credit for the creditor. The interest rate at a given point in time is dependent on the interaction between the amount that savers are willing to save and the amount that borrowers wish to borrow. To understand how the interest rate on credit is determined, assume that the students in your class represent the entire set of borrowers and creditors in financial markets. The savers will serve as creditors by providing their funds to the borrowers. Assume that the students in the first three rows are planning to save some money, while the students in the last three rows will need to borrow money. Also assume that there is no chance that the borrowers will default on the loans that they obtain. AGGREGATE SUPPLY OF FUNDS The amount that the savers in the first three rows will accumulate is dependent on the interest rate that they can obtain on their funds. If you could survey them about how much they are willing to save, you would be able to create a supply 145

23 146 B A N K I N G A N D I N T E R E S T R A T E S curve like that shown in Exhibit 5A.1, which reflects the aggregate amount of funds that will be supplied to the market at various possible interest rates. For a relatively low annual interest rate (such as 2 percent), the aggregate supply of funds is also low because investors do not receive much of a reward. If the nominal interest rate is 6 percent, however, the aggregate supply of funds is higher because the reward to investors is higher. If the nominal interest rate is 11 percent, the aggregate supply of funds is even higher. The supply curve (labeled S 1 ) in Exhibit 5A.1 illustrates that the aggregate supply of funds provided by investors is positively related to the interest rate offered to investors who are willing to supply the funds at a given point in time. AGGREGATE DEMAND FOR FUNDS The amount that the borrowers in your classroom will borrow is dependent on the interest rate that they will have to pay on those funds. If you could survey them about how much they are willing to borrow, you would be able to create a demand curve like that shown in Exhibit 5A.1, which reflects the aggregate amount of funds that will be demanded by borrowers at various possible interest rates. For a relatively low annual interest rate (such as 2 percent), the aggregate demand for funds is very high because the cost of borrowing is so low. When the interest rate is 6 percent, the aggregate demand for funds is lower because the cost of borrowing is higher. When the interest rate is even higher, such as 11 percent, the aggregate demand for funds is even lower. COMBINING SUPPLY AND DEMAND In Exhibit 5A.1, the intersection between the supply curve (S 1 ) and the demand curve (D 1 ) for funds results in an equilibrium interest rate of 6 percent, at which the quantity of funds supplied is equal to the quantity of funds demanded. At Exhibit 5A.1 How an Equilibrium Interest Rate Is Determined Interest Rate (%) S 1 8 i 1 = D 1 0 Quantity of Funds

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