Personal Finance SIXTH EDITION Chapter Banking and Interest Rates Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Chapter Objectives (1 of 2) 5.1 Describe the types and functions of financial institutions 5.2 Describe the banking services offered by financial institutions 5.3 Explain how to select a financial institution for personal use 5.4 Identify the components of interest rates Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Chapter Objectives (2 of 2) 5.5 Explain why interest rates change over time 5.6 Explain how banking services fit within your financial plan Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Financial Institutions (1 of 6) • Depository institutions: Financial institutions that accept deposits from individuals and provide loans – Commercial banks: financial institutions that accept deposits and use the funds to provide commercial and personal loans Deposits insured by Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Financial Institutions (2 of 6) – 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Financial Institutions (3 of 6) • Nondepository institutions: financial institutions that not offer federally insured deposit accounts, but provide various other financial services – Finance companies: nondepository institutions that specialize in providing personal loans to individuals Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Financial Institutions (4 of 6) – Securities firms: nondepository institutions that facilitate the purchase or sale of securities by providing investment banking and brokerage services – Insurance companies: nondepository institutions that provide insurance to protect individuals or firms against possible adverse events Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Financial Institutions (5 of 6) – 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 – Examples include Bank of America and Citigroup Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Financial Institutions (6 of 6) Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Banking Services Offered by Financial Institutions (1 of 7) • Checking services – Checking accounts allow you to draw on funds by writing checks – Paying Bills on Time Fees are charged for – Paying bills after the deadline – Making loan payments after the deadline – Ignoring the rules of a car lease contract, such as maximum mileage allowed Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Interest Rates on Deposits and Loans (4 of 10) • Twisted perception of the risk premium – – – Some investors attracted to investments for the wrong reasons They pursue risky investments to make up for limited income This is faulty reasoning as those with limited incomes can less afford losses Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Interest Rates on Deposits and Loans (5 of 10) • Comparing interest rates and risks – Choice depends on risk tolerance If you will need your money within a year, you should take no risk If you will need a portion of your money when your investment matures, you can afford to take some risk No choice is right for all investors Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Interest Rates on Deposits and Loans (6 of 10) • Term structure of interest rates: the relationship between the maturities of risk-free debt securities and the annualized yields offered on those securities – Often based on rates of return offered by U.S Treasury securities with different maturities Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Interest Rates on Deposits and Loans (7 of 10) • Shifts in the yield curve - Graphs such as the one on the previous slide can be found in financial publications such as the Wall Street Journal and illustrate how returns change over time • Loan Rates - Financial institutions obtain funds by accepting deposits and providing loans to individuals and firms They make a profit on the spread between the two rates Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Financial Planning Online (3 of 3) • Go to www.bankrate.com • Search this site for “federal reserve” • This search will provide updated information about the Fed’s recent actions and upcoming meetings, as well as forecasts of future policy decisions and the potential impact of these decisions Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Interest Rates on Deposits and Loans (8 of 10) EXHIBIT 5.3 Annualized Deposit Rates Offered on Deposits with Various Maturities Maturity Annualized Deposit Rate (%) month 0.20 months 0.24 months 0.45 year 0.70 years 1.00 years 1.25 years 1.60 years 1.70 10 years 3.80 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Interest Rates on Deposits and Loans (9 of 10) Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Interest Rates on Deposits and Loans (10 of 10) Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Why Interest Rates Change (1 of 3) • Monetary policy: the actions taken by the Federal Reserve to control the money supply – Money supply: demand deposits (checking accounts) and currency held by the public – Open market operations: the Fed’s buying and selling of Treasury securities Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Why Interest Rates Change (2 of 3) Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Why Interest Rates Change (3 of 3) • Shift in the government demand for funds – Any change in the government’s borrowing behavior can affect the demand for funds and affect interest rates • Shift in the business demand for funds – When firms adjust their borrowing and spending plans, this affects demand and interest rates Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Banking Services Fit within Your Financial Plan (1 of 4) • The key banking decisions for your financial plan are: – What banking service characteristics are most important to you? – What financial institution provides the best banking service characteristic for you? Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Banking Services Fit within Your Financial Plan (2 of 4) EXHIBIT 5.7 How Banking Services Fit Within Stephanie Spratt’s Financial Plan GOALS FOR BANKING SERVICES Identify the most important banking services 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 I could use the same financial institution if I buy a home in the future Interest rate charged on personal I could use the same financial institution if I obtain a personal loan in the future loans Fees charged for checking services I will be writing many checks, so I would prefer not to pay fees on a checking account if I maintain the minimum balance Location The ideal financial institution would have a branch near my apartment building and near where I work Online and mobile services available This would make my banking more convenient ATMs Check locations for convenience and whether any fees are charged for using ATMs Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Banking Services Fit within Your Financial Plan (3 of 4) EXHIBIT 5.7 How Banking Services Fit Within Stephanie Spratt’s Financial Plan 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 if I maintain a minimum balance I also value convenience, which I measure by the location of the financial institution’s branches, and its online and mobile banking 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Banking Services Fit within Your Financial Plan (4 of 4) EXHIBIT 5.7 How Banking Services Fit Within Stephanie Spratt’s Financial Plan 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 if I maintain a minimum balance, has branches in convenient locations, and offers online and mobile 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved ... “Markets” section and then go to Rate + Bonds” to find interest rate data • This Web site provides some information about individual financial institutions and their relevant interest rates Copyright... Deposits and Loans (1 of 10) • Interest rates on deposits and loans affect your cash inflows and outflows • Certificate of deposit: an instrument that is issued by a depository institution and specifies... components of interest rates Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Chapter Objectives (2 of 2) 5.5 Explain why interest rates change over time 5.6 Explain how banking