Banking Made Simple: Understanding financial fundamentals.
in Managing Money & Credit
Understanding banking basics is a must for anyone who spends, manages, transfers, or inherits money. The topic can feel overwhelming – the landscape of financial products continues to expand, making it ever more complex and difficult to keep up. Unfortunately, only a limited number of Americans are even offered any sort of financial education. Only 17% of high schoolers are required to take a semester of personal finance, according to a recent study by the Council for Economic Education.
Keep reading to build your financial literacy skills and knowledge base. With a little education, you’ll feel equipped to tackle the world of finances head on!
Banking Terminology
As we navigate through some common banking terms, we find that organizing each by type is a good way to fully comprehend the financial landscape.
The topics we’ll cover are:
- Basic Account Terms
- Savings Terms
- Funds Transfer Terms
- Loan/Debt/Credit Terms
Basic Account Terms
Checking Accounts
A checking account allows you to deposit money into it and pay money out of it. It can be accessed using checks, automated teller machines (ATMs), and electronic debits, among other methods. They are often used to keep money for short-term expenses.
Savings Accounts
A savings account is usually interest-bearing and is meant to hold money for some time (generally longer than checking account funds). It can used for a variety of needs, including saving money for short-term or long-term expenses, stashing away money for emergencies, and more. There are typically no deposit limitations, but you are sometimes limited to only a few withdrawals.
Certificate Accounts
Generally, a certificate account will pay higher interest than a savings or checking account. This is because with a CD, you agree to keep the funds in the account for a specified length of time.
Money Market Accounts
Money market accounts are a type of savings account, but they can also offer features that are often associated with checking accounts (like the ability to write a check or use a debit card). They generally pay higher interest rates than checking and savings accounts because banks require you to have a higher minimum balance in them at all times.
Cash Equivalents
“Cash equivalents” are equal (or equivalent) to cash. This means you can withdraw money from them without hassle, whenever you need it.
These types of accounts are considered “liquid” because the flow of money is smooth and unhindered by restrictions, like time requirements. Savings, checking, and money market accounts are generally considered liquid and cash equivalent (CDs would not be considered cash equivalent).
Savings Terms
These terms are associated with saving money.
Interest Rate
It’s important to point out that an interest rate applies to both money deposited to and lent from an institution. In the case of savings, however, we’re referring to the interest that a financial institution pays to you for lending them money (i.e. putting your money in their accounts).
The interest rate is the rate at which you can expect a return on your money. As mentioned earlier, the rate of interest you receive often depends on the type of account you choose to open.
APY (Annual Percentage Yield)
APY is the actual rate of return that will be earned in one year if the interest is compounded (such as with the deposit, savings, money market, or CD accounts you put your money into). Different financial institutions will offer varying rates and account types. You can use this rate as one of the multiple factors to help you determine which savings options are best for you.
Compound Interest
In simple terms, compound interest means that your interest earns interest.
When you deposit money into a savings account, your financial institution pays you interest on it. In a situation where you saved $10,000 and earned 5%, at the end of the year you’d have $10,500. You received $500 just for putting your money in the bank and letting them use it for a little while.
When you start year two, there is now $10,500 in the account and all of that will earn a 5% return (your original $10,000 and the $500 you made). So, in year two, you will earn another $525 in interest because you started the year with a larger balance in the bank. Each year, as you receive interest on the interest you’ve earned in prior years, the money can start to add up.
Funds Transfer Terms
EFT (Electronic Funds Transfer)
An electronic funds transfer is simply a way for banks, businesses, or individuals to electronically transfer money between themselves.
There are two types of EFTs: ACH (automated clearing house) and wire transfers. Wire transfers often require you to pay a fee.
ACH (Automated Clearing House)
An ACH is a method of electronically transferring funds between two parties. A simple example is the direct deposit paycheck you receive that goes directly into your bank account. This is typically an ACH payment.
Wire Transfers
This is the second type of EFT. Wire transfers typically require you to pay a fee, which may vary depending on whether or not it’s incoming, outgoing, domestic, or international.
Loan, Debt, and Credit Terms
These terms are associated with financing.
Interest Rate
When it comes to the interest rate on a loan, this is the money you will pay to a financial institution for borrowing their money. Most loans or credit cards will have an interest portion added to the outstanding monthly balance. When you are seeking a loan or credit card, however, you are likely to see the interest rate expressed in annual terms (APR).
APR (Annual Percentage Rate)
APR represents the annual interest you pay for borrowing money through a credit card or loan. All lenders are required to disclose APRs. Make sure you understand how an APR will affect what you pay over time. It’s also important to understand whether you will be charged simple or compound interest.
Compounded Versus Simple Interest
We’ve discussed compound interest previously so you can understand what this would look like when the tables are turned and you’re the one paying it. Be careful with these loans because what you owe on them can add up quickly if you’re not paying it down quickly enough. Credit card interest is compounding (which is why they can be so hard to pay off).
Simple interest is interest that only ever accrues on the principal loan amount (i.e. you never pay interest on interest). The interest you pay on car loans is a great example of this type of interest.
Fixed Interest
A fixed interest rate on a loan is exactly what it sounds like – it’s set and does not change. This means you can expect it to remain constant for the duration of your loan. This also means that your monthly payment will be the same each month, which makes it easy to know what to budget for.
Variable Interest
A variable interest rate on a loan can vary throughout the loan’s duration. With these types of rates, the rate can vary depending on the terms agreed to when you closed on the loan. This means that what you owe can change – and go up or down – depending on what’s in the loan agreement.
Minimum Payment
A minimum payment is simply what you must pay each month on your loan or debt in order to remain in and good standing and prevent defaulting.
What’s really important to know, however, is that just paying the minimum payment won’t decrease what you owe (unless your loan is rather small). There is a common misconception that paying the minimum payment is enough to eventually pay off your loan; certain lenders may prey on you misunderstanding this point. Make sure that you are paying enough on your loan or debt each month to be paying it down over time.
Prepayment Penalty
Sometimes lenders can put prepayment penalties on the loan. This is less common today, but it is still something of which you must be aware. If this penalty is attached to you loan and you try to pay off the loan early (i.e. to avoid paying future interest), you would be subject to paying a fee.
Equity
Equity is simply the value of an item which a loan was used for minus the total debt still held on it.
An example to make it simpler: if you obtained a loan for $200,000 on a $400,000 home, your equity would be $200,000. You could sell the home for $400,000, pay off your loan, and still have $200,000 leftover – this amount is also known as equity.
Lafayette Federal is Your Financial Partner for Life
At Lafayette Federal Credit Union we seek to make banking simple. If you want to save, we can help you reach your financial goals. If you need a loan, we offer a variety of financing solutions. Reach out to us and we’ll provide you with personalized service to meet your financial needs!
