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. Now let’s talk about how to use banks the right way.
Use Your Bank To Build Your Emergency Fund
Even banks don’t pay much interest, they are still an important tool for you. A sudden bout of unemployment or an unexpected major expense could turn anyone’s financial stability into a horrifying nightmare. The good news is you can remedy that problem faster than you think by building your emergency fund in your local bank.
1. How Much
There are dozens of ways to calculate how much you should set aside for emergencies. You can (and should) consider how liquid your other investments are, how much insurance you have and how stable your income is to make an accurate calculation. But if you don’t want to do that kind of research there is a simpler method. Think back over the last 3 years and ask yourself what was the largest amount of money you needed to get your hands on fast. That’s probably the same amount you need to keep available for tight spots going forward.
There is no way to know for sure how much you’ll need for an emergency that has yet to occur. But regardless of how you run the numbers, make an educated guess and pick your target.
If you don’t have an emergency fund now despite all your best efforts that just means you’re going to have to change some of your financial behaviors. So if creating an emergency fund is a priority you’re going to have to “bring it”.
Let’s say you decide you need $7500 as an emergency fund and you want to accumulate that money in 10 months. You need to cut spending by $750 a month in order to achieve your goal. No magic here. But lots of hard work.
Go through your past spending records and identify where that savings is going to come from.
3. Automate It
Contact your bank and open a new savings account. Set up an automatic monthly deposit of $750 (in this case) funded from your checking account. This puts your savings on auto pilot and makes it very easy to accomplish your goal. You simply must succeed this way. Once you hit your goal, redirect those automatic savings to your investments.
4. Emergency Back Up
Let’s say you have identified how much money you need to save for emergencies and you have no problem hitting your monthly goals. But what happens if an emergency besets you before you are able to reach your goal?
Consider setting up a home equity line of credit if you have equity in your home and do this before an emergency occurs. This will give you instant access to cash when you need it. If a HELOC is not available, think about your other liquid assets as a resource. If all else fails, contact your friends and family and ask them to provide an emergency backdrop just in case.
You don’t want to find yourself in very deep water without a life preserver. Don’t wait to take care of this potential calamity until the sharks start circling. At the same time, make sure you don’t have too much liquid. Believe it or not, this can actually pose a real danger to your retirement.
The bank won’t help you reach your long-term retirement goals but they can help you solve pressing problems during crunch time. Make sure you have adequate emergency cash set aside – despite the low returns.
Don’t Fall Into This Trap When Rates Are Low
When rates are low, you will be tempted to pull all your savings out of the bank and invest for higher rates. It’s a natural thought….but it could be very dangerous. A few days ago a kindly Pilgrim reader (Paul) asked me about breaking a CD’s term, giving up some interest and investing his money elsewhere. He wanted to know if it was a smart move. Sometimes it is….but not always. Here’s an excerpt from the email:
I’m wondering if I should break my CD and pay the penalty to jump out. Although the interest is 2% and that’s great- I’d think I’d be better off dumping the $ into Asset Manager 85/15 fund. It is making 7.9 for this last 1/2 yr. The other idea I am considering is precious metals or short term municipal bonds. What do you think I should do?
I was so happy to get this email and I’ll answer his questions. But more important, I want to take another look at how investments work. I think that might even be more helpful to Paul. Let’s dive in.
“Should I break my CD and pay the penalty?”
Paul understands that when you deposit money in a CD you tie up those funds. That could be for 30 days or 36 months. And if you want your money back before that time is up, you’ll get slapped with a penalty. The size of the penalty varies with the length of the CD. The longer you tie the money up, the greater the penalty.
With a rate of 2% Paul probably signed up for at least 2 years. For our purposes, let’s say the penalty is 6 months interest. In this case, that means he’ll forfeit 1% which isn’t that bad. But let’s go on.
“I’d be better off dumping the $ into my Asset Manager fund. It is making 7.9%”
Paul asks about reallocating his money from the CD to an equity mutual fund, a precious metal fund or a short-term muni bond fund. These are good questions of course. But the answers aren’t simple. That’s because each of these investments have very different risk profiles. I’m not 100% convinced that Paul really understands that.
He’s comparing the 2% CD with the mutual fund and other alternatives based on return alone. No Bueno. What about risk? Sure the fund earned 7.9% in the last six months. But that’s got nothing to do with what the fund might do going forward. It could lose 7.9% (or more) over the next six months for all anyone knows.
Paul is doing what lots of people do – and it’s costly. I could be wrong but based on what he wrote, he seems to think that a fund “earns” a set return – it doesn’t. The CD pays a low rate specifically because it gives you something the fund can never give – certainty. Paul needs to really understand what mutual fund returns really mean.
Paul asks about precious metal funds and municipal bond funds too. These are very different investments compared to the CD as well. Precious metal funds are speculative and very aggressive investments. Bond funds on the other hand are typically much more conservative but still more risky than CDs. It feels like Paul is comparing investments based purely on what the returns might be. Aye Carumba!
How To Avoid Falling Into This Trap
Before you invest a dime, get clear on your investment time-frame and ultimate objectives – and keep in mind that other considerations might be far more important than return on investment. Think about when you’ll need the money back and how much risk you are willing to take during the term too.
If you own a CD and you don’t think you’ll need the money for 5 years or more it might be smart to break the time deposit and invest elsewhere. (If that is the case ask yourself why you bought the CD in the first place)
If, on the other hand it’s likely that you’ll need the money within two or three year, you might stick with the CDs. The return will disappoint you but you’ll have safety and liquidity. Most important, you know the money will be there when you need it.
In short, investing is about return – but it’s not only about return. When liquidity and safety are very important, a CD might be the very best way to go.
Bottom Line On Banks
No matter how you’ve arranged your finances, chances are you have at least one banking relationship. But are you using your bank well or is your bank using you? It’s an important question because not only can banks dip into your pocket, they can also lead you down the wrong path – and that can be far more expensive.
Over the last 30 years I’ve noticed 3 main areas of concern and opportunity when it comes to banks. Let’s get right to it.
They don’t build banks as a public service. Banks are in business to make money and they make that money from you. They do that by charging you fees. And just so you know, they also provide big incentives to their employees to sell you as much as they can in order to rake in as much as possible.
Banks charge fees for everything from printing your checks to maintaining your account. And while most banks are transparent about those charges, sometimes overzealous bank employees get carried away. Case in point, the City of Los Angeles is suing Wells Fargo for allegedly pushing their employees to open up unauthorized accounts . That ended up ripping off customers and hurting their credit scores in many cases. This was all done just so the bank would earn bogus fees. Yuk.
Here’s a short list on how to minimize your banking costs:
a. Shop around.
You may not need a brick-and-mortar bank anymore. Online banks are generally cheaper, charge fewer fees and are more transparent in my experience.
b. Get your checks printed elsewhere.
You might need a bank for a checking account but you don’t need a bank to be your printer. Many banks will give you your first order of checks for free. If you need more, order them from an online check printer to save a few pesos amigo.
c. Ask questions.
Anytime you open or close an account, ask about costs. Make sure you write down who you speak with and what they tell you. To make sure they are on the up and up, ask to see proof. Often you’ll talk to one bank clerk who wants to sell you something and they’ll invent whatever they have to in order to get you to sign on. But then when you get your statement, you find out they weren’t being completely honest. You can avoid that by asking your bank rep to show you where the fees and charges are spelled out in the bank literature. If you take this one step, you’ll avoid the unpleasant situation of discovering the truth after it’s too late.
Products to Use
You’re not going to profit much by keeping money in the bank once you consider taxes and inflation. But you need liquid money and the bank is a decent place to use for that purpose. Just make sure you don’t keep too much laying around in the bank and then relax.
The bank won’t pay you much but don’t get uptight about it. First, rates are so low that even if another bank pays a little more, it probably won’t amount to much. Second, you normally won’t have too much money in the bank anyway so again, it probably doesn’t matter.
Some folks get worked up and spend lots of time and energy looking for the best interest rate for liquid funds. I get it. But if you do the math and calculate what that extra interest adds up to, you’ll probably learn that this is just not something to worry about.
Products to Avoid
While savings and checking accounts are a necessary evil for most people, beware of CDs. For most people, these are products that pay pitifully low interest and lock your money up for way too long. For most people, there are far better long-term investment choices.
Among the bad bank products, CDs are among the benign. It gets really bad when the bank tries to sell you investments (and I know about this because I started my career selling investments in banks). Bank “investment professionals” work on commissions. That means they make more money when they sell you something – whether you need it or not.
And some products like annuities (double Yuk) earn the sales people much higher commissions that other investments. Either way, I am a big opponent of buying financial products from commission-based people so stay away. Call me crazy but I like my advisor to have their interests aligned with mine and not their employer’s.
Banks are necessary and they are not evil per se. They offer valuable services that you need. But they get to use your money and pay you almost nothing in return. They make huge profits by taking your money and lending it to others. They don’t need to make more money by charging you bogus fees and selling investments.