Personal Finance - Chapter 5 Banking and Interest Rates PDF

Personal Finance SIXTH EDITION Chapter 5 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...

Personal Finance SIXTH EDITION Chapter 5 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 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  UAE central bank guarantees full amount of the deposits. 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 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 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 Banking Services Offered by Financial Institutions (2 of 7) Checking accounts – Banks commonly issue debit cards tied to your checking account – Mobile banking using smartphone apps is now common – Online banking is also gaining popularity  Online bill pay  Online account transfers  Electronic deposits Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Banking Services Offered by Financial Institutions (3 of 7) – Monitoring Your Account Balance  Record checks in your checkbook as you write them  Bounce cheques  Article 401 of the UAE Federal Penal Code provides that the drawer of a bounced cheque should be sentenced to detention of a period not less than one month and not more than three years, while the fine is for an amount not less than AED 1,000 and not more than AED 300,000. – Reconciling Your Account Balance  Make sure the bank statement agrees with your check register Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Banking Services Offered by Financial Institutions (4 of 7) EXHIBIT 5.2 Example of a Worksheet to Reconcile Your Bank Statement Beginning balance Deposits = $1,500 $100 $400 $500 Withdrawals → + $500 → - $200 → - $800 → - $200 $50 $150 $200 Checks that have cleared $700 $100 $800 Debit card transactions $25 $50 $125 $200 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Banking Services Offered by Financial Institutions (5 of 7) EXHIBIT 5.2 Example of a Worksheet to Reconcile Your Bank Statement Automatic bill payments $100 $100 Bank fees $200 → - $200 $0 → -$0 Balance shown on bank statement Checks that have not yet cleared $600 $100 $100 $200 Adjusted bank balance (your prevailing bank balance) Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved → - $200 $400 Banking Services Offered by Financial Institutions (6 of 7) Check float—the time from when you write a check until your checking account balance is reduced – UAE Banks Will Clear Cheques on Same Day (November 2009) – Electronic checking deters fraud. because the payee knows if there are sufficient funds in the customer’s account to make a purchase. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Banking Services Offered by Financial Institutions (7 of 7) Credit card financing such as Visa and Mastercard Debit card: a card that is used to make purchases that are charged against a checking account Interchange is a small fee paid by a merchant's bank (acquirer) to a cardholder's bank (issuer) to compensate the issuer for the value and benefits that merchants receive when they accept electronic payments. It enables banks that issue electronic payments to deliver tremendous value to merchants, governments and consumers. – Debit cards for Teenagers  Convenient way for parents to transfer funds to children, but may encourage overspending Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Additional Services Financial Institutions Offer (1 of 3) Safety deposit box: a box at a financial institution where a customer can store documents, jewelry, or other valuables Automated teller machines (ATMs): a machine where individuals can deposit and withdraw funds any time of the day – Fees can be charged for using another financial institution’s ATM Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Additional Services Financial Institutions Offer (2 of 3) Cashier’s check: “is a check guaranteed by a bank, drawn on the bank's own funds and signed by a cashier. Cashier's checks are treated as guaranteed funds because the bank, rather than the purchaser, is responsible for paying the amount.” Wikipedia definition. Money order: a check that is written on behalf of a person for a fixed amount that is paid in advance Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Additional Services Financial Institutions Offer (3 of 3) 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Selecting a Financial Institution Criteria Used to Select a Financial Institution – Convenience  Close to where you live or work, convenient ATM locations, online banking – Paying bills online – Deposit rates and insurance  Comparison shop for best interest rates – Fees Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Interest Rates on 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 a minimum investment, an interest rate, and a maturity. In UAE it is issued by Central Bank for banks. Risk-free rate: a return on an investment that is guaranteed for a specified period even if the banks goes bankrupt. It is about 2.5% in UAE. Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Interest Rates on Deposits and Loans (2 of 10) Risk premium: an additional return beyond the riskfree rate that can be earned from a deposit guaranteed by the government Risk Premium=Return-Risk Free rate Loan rate—financial institutions loan money at a rate higher than they pay depositors – Individuals with a poor credit history pay higher rates Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Interest Rates on Deposits and Loans (3 of 10) Impact of the economy of the risk premium – When economic conditions weaken, firms issuing securities must pay a higher risk premium to sell their securities, resulting in investors reluctance to purchase the securities for fear the firm might go bankrupt and not repay their debt – Investors more willing to invest in a favorable economic climate 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. The higher risk premium on investments during a weak economy is offered as compensation to investors for accepting more risk. – if you have limited income because of a bad economy, a more rational strategy would be to focus on safe investments even if they offer a lower return, so that you can avoid any losses in case you need the funds that you invested. 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 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 (%) 1 month 0.20 3 months 0.24 6 months 0.45 1 year 0.70 2 years 1.00 3 years 1.25 4 years 1.60 5 years 1.70 10 years 3.80 Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Loan Rates 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. Therefore, to borrow funds, you must normally pay a higher interest rate on the loan than the prevailing rate offered on deposits. 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 Central Bank 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. it increases the amount of funds at commercial banks by using some of its reserves to purchase Treasury securities held by investors. 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. If the government reduces (instead of increases) the amount that it borrows, there will be a surplus of funds at the original interest rate, which will result in a lower interest rate. 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