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The Basics of Banking Explained

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This is the first edition of our Personal Finance Foundation Series where I discuss the very basics of foundation-type personal finance topics. The topic of this post is Banking.

I was fortunate that my first real experience with banking was with a local credit union. Credit unions are really great about welcoming new members and educating them about everything. Commercials banks, while still cordial, simply don’t offer the same types of services that credit unions do. My mom and I opened a joint banking account a local credit union when I was fourteen and I was excited to even have a laminated blue card with my account number and credit union phone numbers! I still have the card in my desk drawer, I still have the account open, and it was a nice warm and welcoming introduction to the banking world.

That, however, seems to be atypical. Many people are introduced to the banking world either through the nastiness of credit cards or by walking into the antiseptic branch of a major bank. You open an account, direct deposit your paycheck, and feel like a number in a database. There is no education, no explanation, just an assumption that “you’ll figure it out eventually.” Well, unfortunately that isn’t enough because “figuring it out” usually results in you being dinged on fees so let’s start from the basics and go through what banking is.

What is Banking?

In general, banking is the business of paying interest to customers for their deposits and then lending those deposits out at a higher interest rate. Whether it’s a commercial bank or a credit union, the basic idea behind banks is the same. They are able to earn money by borrowing it at a lower rate and lending it at a higher rate. Banks also provide ancillary services that help you manage your money more easily, like being able to use a debit card or personal checks, but the main business of banks is in getting deposits and granting loans.

Commercial Banks and Credit Unions

For all intents and purposes, most banks are either commercial banks or credit unions. There are other organizational structures but for the the average consumer, the differences are really minor and you only need to be aware of these two types. (here is a full discussion about the differences between banks, thrifts, and credit unions)

The primary difference between a commercial bank and a credit union is that commercial banks exist to generate profits and credit unions exist to serve its members. This philosophical difference is translated into reality by the interest rates the banks offer on their deposit accounts and their loans. Commercial banks usually offer lower rates on their deposit accounts and higher rates on their loans. This is why people, myself included, recommend having at least one credit union account because it will give you access to the lower interest rates for loans, such as mortgages and car loans. (here are ten reasons why credit unions rule)

Opening an account at a commercial bank is fairly straightforward, you’ll need to visit a bank or apply online and be able to fill out all your personal details including your social security number. Opening an account a credit union is a little trickier because a credit union, by law, has to have membership requirements. Sometimes they are open only to people living or working in a particular town or only to employees of a company or members of an organization. Whatever the rules are, you should be able to find a credit union that you are eligible for, it’s just a small hoop to jump through.

Types of Bank Accounts

There are four major “types” of deposit accounts at a bank: a checking account, a money market account, a savings account, and certificate of deposit. There are a few things you need to look out for whenever you open a deposit account at a bank. Always review the fee structure of the account, you always want to avoid paying any fee whatsoever. If an account has a maintenance fee that you can’t get waived, don’t open it. If it has fees you don’t understand, ask about them. Also check for a minimum balance requirement and whether it’s reasonable. If the minimum balance is more than $1,000 – skip it because you can find a bank without such an onerous requirement. My credit union has no minimum balance (well, technically it’s $1).

A checking account, also known as share draft accounts at credit unions, are designed for you to use on a daily basis. You will be issued checks and an ATM debit card that draws from this account. Checking accounts typically will have a low or no interest and “unlimited” transactions each month (the limit is usually very high).

A money market account, also known as a money market account at credit unions, is less flexible than a checking account but offers a higher interest rate. You may be issued a card and checks but you will be limited in how many transactions you can have each month (the limit is six and governed by Federal Reserve Regulation D). I compiled this list of the best money market accounts currently available.

A savings account, also known as regular share accounts at credit unions, is less flexible than the checking and money market accounts. In return for this inflexibility, it will have higher interest rates and be limited to 6 external debit transactions each month (as required by Federal Reserve Regulation D). You can have an unlimited number of deposits, whether they are cash, credit, ACH, etc. You will never get checks for a savings account, the external transfers are limited to ACH transfers, if any at all.

A certificate of deposit, also known as share certificates at credit unions, are the most restrictive of the four account types. With this account, you are guaranteed interest rate for the term of the CD but you cannot move the money inside the CD. If you need access, the only option you have is to close the account before maturity and that will trigger an interest penalty. For example, if you open a 12-month 4% CD, you will earn 4% APY on your money in that account for twelve months (here are the best CD rates). The rate will not go up or down but you don’t have access to it unless you close out the account. (Some banks are offering “liquid CDs” where you are allowed to deposit or withdraw a small amount without penalty)

ATM & ATM Cards

ATM stands for automated teller machine. When you visit a bank, the person behind the counter is called the teller, hence the name automated teller. With the ATM card, you will need to remember your PIN, or personal identification number. When you slide your card into the machine, you’ll be prompted for your PIN as a way of proving you are who you say you are. Through the ATM, you can conduct very basic business transactions such as depositing money, withdrawing money, and checking your balance. Anything more complicated, like opening a new account, and you’ll need to talk to a real teller. As a rule, I never deposit cash into an ATM though that’s just a superstition on my part.

Make sure you are using an ATM that is affiliated with your bank and won’t charge you an ATM access fee. If you use a non-affiliate ATM to withdraw cash, you will often be charged two fees. First, the owner of the ATM will charge you a few dollars. Second, your bank will charge you a few dollars. It’s an ugly double whammy that catches many people. If you’re in a tight spot and have no choice, by all means get some cash; but if you can avoid it, please do and save yourself some money. ATM machines and banks make billions each year on these fees.

Many banks offer ATM fee refunds. If your bank offers this, you can save some money on fees even if you need to go to a non-affiliated ATM. Other banks may waive ATM fees altogether. Check with your bank to find out.

ATM cards sometimes may be used as a debit card. A debit card looks like a credit card, except when you spend money it gets immediately withdrawn from your checking account. It’s safer than a credit card because you can’t go into debt, you can only spend the money that’s already in your account. It’s more dangerous than a credit card because if you charge something and your account doesn’t have the money, you may be charged a fee. There are other risks with debit cards but understanding the basics will be enough for now.

Personal Checks

A personal check is an IOU against funds in your checking account. If you look at the bottom of your checks, you should see a series of numbers separated by symbols that look like three boxes. Those numbers coincide with your bank’s ABA routing number (a 9-digit number), your checking account number, and your check number (probably the smallest number of the three). The ABA routing number and your checking account number are two important things to know because you will need that to set up any automatic payments or electronic payment accounts.

It is important to keep an accurate record of the checks you write because they won’t show up in your checking account until the person cashes it. Some people can hold checks for a few months before they remember to cash it. Just like debit cards, if someone tries to cash a check and you don’t have enough money, you’ll be charged a fee (NSF – Insufficient Funds Fee).

Don’t buy checks from the bank. Some banks will give you checks for free, some banks will charge you an absurd amount of money for checks. If you have to buy checks, buy them from a reputable company online like Checks Unlimited because you can get them for a fraction of the price. If you want better designs on your checks, those companies are always going to have a better selection than the bank because Checks Unlimited signs exclusive partnerships with companies like Disney and Warner Brothers to use their characters on checks.

Fees

Since we’re on the topic of fees, let’s hit the major fees banks are most likely going to try to charge you and discuss how you can avoid them:

  • Account Maintenance Fee: Typically only a few dollars, it’s a fee that is charged if you don’t fulfill minimum balance requirements. I believe you should never open an account at a bank where there’s a minimum above a few hundred dollars. You can avoid this fee by keeping your average daily balance above the requirements.
  • Overdraft & Insufficient Funds Fee: If you, either through your debit card or a personal check, overdraw your account, you’ll be hit with this fee. Overdrawing simply means you wrote a check or made a charge and your account didn’t have enough money. Sometimes the bank will pay the charge, then charge you a fee, and require you to deposit more funds. Sometimes they reject the charge and then charge the fee, either way you’re getting dinged. Avoid this by keeping a check register and having a clear idea of how much money you have in the account.
  • Stop Payment Fee: Let’s say you write a check and then want to stop the bank from paying it out (for any reason, perhaps fraud or a mistake). If you can’t get the check back, you can initiate a Stop Payment. The best way to avoid this is to not use checks!
  • ATM Fee: If you use an ATM that isn’t in your bank’s network, you’ll be charged a fee as described in the ATM & ATM Cards section above.
  • Check Enclosure Fee: This is a fee you pay if you want your canceled checks returned. Canceled checks are those checks you wrote, someone else cashed, and have been returned to your bank. You can avoid this fee by simply declining the check enclosure service, you won’t need it anyway.

Overdraft Protection

Overdraft protection is a service where your checking account is “protected” by your savings account. Should you make a charge to your debit card or write a check when your checking account doesn’t have enough money to cover it, overdraft protection will transfer money or will give you a short term loan with interest until you can deposit funds to cover it. If you never use it, it doesn’t cost you anything. If you slip up and have to use it, the interest you pay is always less than the Overdraft or Insufficient Funds Fee ($30-35). One thing to be wary of, watch out for transfer fees and check with your bank about the specifics of the protection.

Online Banks

In the last five years or so, online banks have emerged as a great place to save your money and earn a higher rate of return. Online banks can be standalone entities or be associated with well known brands like ING, HSBC, FNBO, and the like. Whatever the case may be, it’s important to always due your due diligence and ensure that your funds are FDIC protected.

Online banks are able to give such a high interest rate because they keep their costs low by only offering an online interface and requiring you to accept paperless statements via email. The highest interest rates for online banks still beat the relatively pedestrian rates of brick and mortar banks, who have to support branches and employees.

FDIC & NCUA Insurance

The FDIC is the Federal Deposit Insurance Corporation and they insure that your deposits at a bank are protected against a bank’s failure. The NCUA is the National Credit Union Administration and is the FDIC-equivalent for the credit union industry. The FDIC protects up to $100,000 of your assets at an FDIC-insured institution (that limit was recently increased to $250,000 until December 2010). It doesn’t matter if you have one account, two accounts, or eight accounts at a bank, the FDIC covers up to $100,000. If you have one account at Bank A and another at Bank B, then you have up to $200,000 of coverage; $100,000 at each bank. There are other account types that can increase your FDIC insurance coverage but that’s not really worth going into.

Taxes

Finally, the least entertaining topic about banks has to deal with taxes. The interest that you earn on your deposit accounts is subject to income tax. At the end of the year, your bank will send you a form 1099-INT. That form will explain how much interest you’ve earned through the year and you will put that on the tax form or into your tax software. Be sure to get a 1099-INT from every one of your banks because you will have to declare all that as income. If you don’t and the IRS audits you, they will penalize you on the taxes that you didn’t pay but should have.

So, what did I miss? I consider this a work in progress so if I missed something please let me know so I can add it!

Many thanks to reader Joe S. for helping me out on clarifying and adding to this resource!

(Photo: dominicspics)

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13 Responses to “The Basics of Banking Explained”

  1. Miranda says:

    Thanks for the great post! Education is an important step in learning how to properly manage money, and understanding modern banking — and your options therein — is a great way to start.

  2. John says:

    What did you miss? That depends a bit on how the series are set up… But perhaps the following questions could be answered: can you use your ATM Card in a foreign country? Are there any extra costs involved?

    • AverageJoe says:

      Most ATM cards can be used in most developed countries. Look on the back of your card, there are different logos describing which networks your card can access. Also call your bank and ask them how to get a list of locations in the cities you’ll be visiting. Many times there is an extra fee for overseas ATM transactions involving currency exchange, on top of the ATM fee charged by the bank that owns the machine you are using. Lastly, let your bank know when and where you’ll be traveling so the fraud department doesn’t cancel your card due to “suspicious activity”!

  3. theoddbod says:

    more than i’ve ever learned from my bank ;)

  4. thomas says:

    Great explanation of banks and their services. I would also note that using your ATM card at machines other than your banks can result in double charges – one from your bank penalizing you for not using theirs and one from the issuing bank (or service) charging you for their great service.

    If you have to pull money out, make sure you pull out a higher percentage of cash to avoid such an excess fee. $.75 from my bank and $1.50 to pull out $20 results in 11% fee. Pulling out $100 knocks it down to 2.25%.

  5. Many many months ago I wrote about how the banking industry works. As someone who works for a bank I’ve learned a lot about internal motivations.

    Banks are no longer interested in making money from their loans, often referred to as spread revenue. Spread is the difference between the rate a bank uses to pay interest and the rate it charges the borrower. For argument’s sake, say the spread on a 6% mortgage is 2%. The other 4% is used to pay back to depositers (mostly CDs). The banks don’t care as much about spread anymore.

    They want the fees. They want origination fees, advisory fees, management fees, insufficient funds fees, late payment fees, blah blah blah. This is why we’re in a heap of mess because the mortgage folks only cared about the fees. The guy who got your mortgage will sell it anyway, so they don’t mind as much not making money on the spread.

    What they don’t want you to know is these fees are often negotiable. The spread is usually locked to your income level, type of loan, and credit rating, but fees are negotiable. You’re most likely dealing with commissioned officers when obtaining fees and they have discression to reduce the fee to get your business.

    I tell you all of this because I think it’s sad the banks are no longer interested in simple spread revenue.

    Jim, feel free to pluck whatever you want from what I’ve written:

    http://weakonomics.com/special-features/college-of-weakonomics/
    “Weakon 151 Parts I and II”

    PS, your post was spot on though!

    • AverageJoe says:

      I agree completely. Most banks simply look at accounts as opportunities to charge fees for this and that, it’s really a shame. DO NOT pay excessive fees! Ask your bank how to avoid them, and don’t be afraid to ask for a manager if you’re looking for a refund. Or for that manager’s supervisor. Just always be polite and express your desire to stay with the bank if the situation can be resolved, that will get you the best results.

  6. srikks says:

    Are the interests earned in high reward checking accounts and Certificate of Deposits taxable too?

    • jim says:

      Yes, they are. All interest you earn at a bank is taxed.

      • technically yes and technically no – you can open up a Roth IRA and simply put a CD in the Roth.

        99 times out of 100 Jim’s right though. Interest earned is taxed. I got a letter today from the IRS saying they owe my $11 and I need to report that as income.

  7. James says:

    Not sure if you want to go into this kind of level of detail, but on FDIC insurance you may want to explain coverage for joint v. individual accounts.

  8. Jim – this is great and I have forwarded the link to my son who is in college. He’s called me a couple of times about the difference between available balance and actual balance – or something like that. He says it’s listed on his ATM slip. I’m sure he’s not the only one who doesn’t know the difference so that might be a good thing to add. I may have the names wrong as I don’t actually see this on my slips. I always tell him to go by the smaller one!

  9. kanika says:

    Thanks jim!! for such a fine article which absolutely helps to understand the basics of banking!!


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