Bank deposits won’t help you become wealthy but they can be a very important way to hold on to your wealth. That’s why they are so important to understand.
When you deposit money in a bank, they usually promise to pay you interest in exchange for “lending” them the money. While you have the money on deposit with them, they pay you interest. And when you withdraw the money from the account, they stop paying. Simple.
You have access to the money you deposited in the bank at various times. If you put your money in a savings or checking account, you have access to your money whenever you want it. You can withdraw the money in cash or get a bank check. If you have a checking account, you can simply write a check in order to withdraw funds.
If you have a CD or Certificate of Deposit, you will probably have to keep your money on deposit with the bank for a set period of time. For example, if you buy a 6 month CD, you’ll have to keep your money in the bank for 6 months. If you pull your money out of the bank prior to maturity, you will likely pay a penalty in the form of forfeited interest.
If you buy a 3 or 6 month CD (a Certificate of Deposit that matures in either 3 or 6 months) the bank will ding you 3 months’ interest if you pull your money out of the bank prior to the maturity date. If you have a 1 or 2 year CD, the penalty is usually 6 months. And if you buy a 5 year CD you’ll forfeit 1 year’s interest if you break the terms of the account.
It’s conceivable that if you break the terms of your CD your penalty could be larger than the interest that you’ve earned. If so, the difference will come out of your principal. Sorry.
How can banks afford to pay interest?
When you deposit money in the bank, they don’t just sit on your cash. They lend out your money to other people who need mortgages, car loans, refinancing etc. They charge those people more than you charge them for borrowing your money. That profit belongs to the bank and that’s how they stay in business.
What if the people borrowing money from the bank don’t pay up?
Knowing that your bank takes your deposits and loans out the money, you might be concerned about the credit worthiness of those borrowers. In most cases, you probably don’t need to fret.
Bank CD’s, checking accounts and savings accounts are protected under the Federal Deposit Insurance Corporation (FDIC). You are covered up to $250,000 per institution. So if you have an account in 4 different banks, you could have up to $1,000,000 of coverage from the FDIC.
The FDIC is an independent agency of the U.S. government and it backs you up if your bank fails (up to the limits described). The good news is that even though the FDIC is only an agency of the U.S. government, it is backed by the full faith and credit of the United States. The FDIC was created in 1933 and since that time, no investor has ever lost a cent in an FDIC-insured account.
More on that FDIC coverage.
As I said, if you have money on deposit with an FDIC-insured institution, you are covered up to $250,000. Keep in mind that this $250,000 limit is applied to any account you have at that bank – even if your accounts are at different branches or in other banks that are owned by your bank.
If you own a joint account the $250,000 limit only applies to your portion of the account. So if you and your spouse have $500,000 in the bank in a joint account where each of you own half the account, you would each have $250,000 coverage – or a total of $500,000.
Trusts offer even more coverage. The insurance limit is calculated per beneficiary per owner. Let’s say Jim and Mary have 2 children which are the beneficiaries of the trust. Each child has FDIC coverage of $250,000 from Jim and $250,000 from Mary – for a total of $500,000 FDIC coverage per beneficiary. So as long as the account value stays below $1,000,000 the account is fully covered.
How safe is the bank?
You might conclude that you have nothing to worry about when it comes to banks. To some extent you are right but there are still areas of concern.
Banks are run by people and while most people are honest, some are not. The people who work in the bank have access to your money and your data and sometimes they misuse both. The recent $185 million fine levied against Wells Fargo puts a spot light on this issue. Over 5,000 Wells Fargo employees were found to have opened up phony credit cards and accounts in the names of real bank customers in order to meet quotas. While in this case, it looks like very little money was involved, this could still hurt customers’ credit scores and that could be costly.
The Wells problem is unique in that the scope of it was so large but it is by no means a limited problem. Because bank staff has access to your money and information you have to take steps to safeguard both. The best way to do that is to check your bank balances and transactions online every few days.
What about Credit Unions?
At first glance, banks and credit unions might look about the same. They both offer CDs, checking and savings accounts, sell mortgages, car loans and credit cards.
The big difference is that banks are for-profit and credit unions are not. Banks charge as much interest as they can when they loan out money, pay out as little as possible to depositors and pay the profits out to shareholders in the form of dividends. But credit unions try to charge lower fees, pay higher rates of interest to depositors, and distribute profits back to its customers.
Another difference between the two lies in the insurance backing them up. While the FDIC covers member banks, credit unions are covered by the National Credit Union Administration (NCUA). The good news is that this is also a branch of the federal government and is backed by the full faith and credit of the U.S. government.
Who decides how much interest the bank will pay?
Banks can pay you any rate they want on your CD’s, checking and savings accounts. If one bank wants to offer 10% for a 1 year CD they can and nobody would stop them – except the marketplace.
Remember, the bank makes a profit when they rent your money from you at a lower rate than what they charge borrowers. For example, right now, borrowers can get mortgages for about 3.5%. That means that the bank has to pay you less than that if they want to make a profit. In fact, if they want to make a profit, they have to pay you a lot less than that. Remember, they have to pay their expenses like wages, rent etc. and still profit. That’s why rates depositors earn are much less than the rate the bank charges for those who want to borrow money.
Having said that, the longer you tie up your money with the bank, the more they will pay you in most cases. That’s because the bank takes on less risk with long term deposits and they take more risk with short term deposits. Here’s how that works.
If you put your money in a checking account, the rate they pay changes – sometimes daily. Let’s say the bank pays you .5% for the money you keep in your checking account today. The bank has to lend that money out of course and let’s say they do so at 4% which gives them a sweet profit of 3.5% per year.
Of course, the rate they pay you on checking accounts isn’t fixed and will rise and fall with prevailing interest rates. Let’s say interest rates go way up and after a few years they have to pay you 5% on that dough you have stashed away in your checking account. Now, instead of making a profit, the bank is losing 1% per year on your money. They have to pay 5% but are only earning 4% on the money. That’s the risk the bank takes. Because short term deposits pose a huge risks to banks, they pay very little interest on them.
Now, let’s say the bank can pay someone else 3% to lock the money up for 5 years. Now, they can breathe easy and match up their deposits with their loans. And as long as they loan money out for 5 years for more than 3% they have no risk. Get it? This is why you will earn more at the bank when you lock your money up for longer terms.
This explains most of how banks set interest rates but it’s not the complete story. The Federal government also plays a part in this. Banks also borrow money from the Federal Reserve bank. The rate they borrow at is referred to as the Federal Discount Rate. And banks can also borrow from each other at a rate set by the Federal Reserve (known as the Federal Funds Rate) . This rate is usually a little lower than the Federal Discount Rate, but I digress.
The reason the government gets involved in lending money to banks is because this is a safety net of sorts. They regulate rates this way. Regardless of what consumers are doing, if the Fed decides they need rates to drop (to stimulate the economy) they can lower the Federal Discount and Federal Funds Rates. If the Fed does this, banks have lower costs and it makes it more profitable for them to loan money to consumers at lower rates. With more money in circulation, the Fed (hopefully) achieves its goal of getting the economy moving.
The Fed can also reverse this in order to slow the economy down. If the Fed raises these rates, it makes it more expensive for banks to obtain funds. This means banks charge more to lend money out. Since loans are harder to get, business activity contracts and things slow down.
Is the bank a good investment?
As I hinted above, the bank is not a place to build wealth. That doesn’t mean you should avoid banks at all costs. In reality, banks can be both a wonderful and a terrible place to put money. It depends on your objectives.
If your main goal is stability and having access to your cash (known as “liquidity”) bank products might be for you. That’s because the value of your FDIC insured deposit is stable and there is no market fluctuation involved. The only way you can withdraw less than you deposited is if you break the terms of your Certificate of Deposit.
Does that mean investing in bank CDs and checking accounts is the way to go. Not really. You see, while the value of your account won’t fluctuate down, it also won’t fluctuate up more than the interest you earn. And that means, deposits in the bank rarely grow fast enough to keep pace with inflation. And if you take out the taxes you pay on interest earned, the picture becomes even more depressing.
As you see below, in the vast majority of cases, people lose money each year when they keep money in the bank.
Bottom line? For most investors, the CD is not a viable alternative for long-term growth. It is a great (and possibly the only) choice for people who need access to their capital over the short-run but not as a long-term wealth builder.