Sometimes it seems like you need a Ph.D. to understand what banks are talking about. Checking accounts we get, sure. But money market accounts? CDs? Variable interest rates? We just want somewhere to keep our money!
For that reason, most of us, when we set up our banking, just walk into a big-name bank, grab the first person we see with a name tag and say, “I need to open a checking account.”
No wonder less than half of women in the U.S. report feeling satisfied with their financial stability, according to the American Psychological Association. How can you possibly feel good about your finances without knowing the fundamentals of banking?
Checking accounts are one of the most popular deposit accounts opened at financial institutions, so you probably already have your hard-earned funds sitting in an account waiting for your next expense.
But even if you’ve already opened a checking account, it’s never too late to understand how your bank handles your funds and helps you manage your money. The sooner you get a handle on it, the sooner you can reap all its benefits.
Banking in a Nutshell
Banking is a general word that describes all the services offered by a bank, credit union or other financial institution. Primarily, these institutions deal with two types of products: deposit accounts and loans.
Examples of deposit accounts include: checking accounts and savings accounts which are the most commonly used, certificates of deposits (also known as CDs), money market accounts and individual retirement accounts (IRAs). With deposit accounts, customers like you entrust the bank or financial institution with the safekeeping of your money for a short-term or long-term period.
Another popular banking service is loans, which is how banks make money for a profit. Banks loan money to you, if you qualify, for big-ticket items such as a mortgage loan for your dream home, a student loan to help send your daughter to her top-pick university, or a personal loan to pay for an unexpected medical bill. Bank loans allow you to pay for major expenses using money you don’t immediately have.
How Banking Works
What you may not realize, however, is what happens behind the scenes.
n. A financial institution that holds money in deposit accounts and also lends money to individuals and small businesses.
n. A nonprofit financial institution owned and operated by its members. Credit unions often provide similar products as that of a bank.
n. The percentage of interest a financial institution pays to customers for depositing money into a deposit account.
n. The percentage of interest a financial institution charges customers for borrowing money from the bank.
n. What banks offer customers to hold their money for deposits and withdrawals for the short and long term. There are three different types of deposit accounts which include: transactional deposit accounts, savings deposit accounts and time deposit accounts.
n. Funds borrowed by an entity or person, which the borrower pays back to the lender in full, with added interest.
As you deposit money into a deposit account like your savings, the bank borrows your money and puts it into a pool of funds used to loan out to other customers. A common misconception is that when cash is deposited into your personal account, that same cash is left idle in your deposit account until you withdraw it. In reality, your money is circulating to feed a massive economic cycle so that you, your friends and your family can purchase homes, buy cars and borrow when needed.
By this point, you’ve got to be wondering: why on Earth do banks do this?
Banks, like any other commercial establishment, are a business. Their main goal is to make money, which they do with interest rates.
When a customer like you is approved for a bank loan, you pay the bank interest on the amount you borrowed. The bank then gives a small portion of that interest to depositors as a “thank you” for letting the bank loan out your original deposit (and to give you incentive to continue depositing money into the account). The bank keeps the remainder of the interest from the loan as profit.
Surprised to find out your money doesn’t actually stay put with the bank? Well, rest assured banks are required by the Federal Reserve Act to have reserve funds (i.e. money set aside) should you ever want to withdraw your money. However, if there were to be a crisis and every single customer wanted to withdraw her money all at once, there is a high chance that the bank wouldn’t have enough to go around. (See this article to find out what happens if your bank fails.)
Why Banking Is Important
At first, you may feel a bit betrayed—after all, you deposited your money trusting that the bank would keep it safe and accessible to you when you most needed it. Now that you know exactly how banks operate, you can learn how to benefit from the cycle.
Here are a few reasons why banking is important for your bottom line:
- It earns you money. By depositing (i.e. lending) your money to a bank, you’re earning interest and growing your own profits. This means that financially, you’re that much closer to reaching your goals for a down payment on your first home or saving up for a new iPad.
- The government will insure money you keep in the bank. Most financial institutions are insured by a third-party federal entity like the Federal Deposit Insurance Corporation (FDIC) The FDIC is the U.S. corporation that insures deposits in the U.S. against bank failure. Its purpose is to maintain public confidence in the financial system and to promote sound banking practices and stability in the financial system. or the National Credit Union Association (NCUA) in the event a bank goes south. What does this mean for you? It means that even if a bank fails, you are guaranteed to get back every single dime you’ve deposited up to $250,000. You can’t get that kind of guarantee from your mattress!
- Bank products help you budget. Banking products give you the ability to easily divide up your money to reach different goals. For example, you can allocate $1,500 to your checking account per paycheck, $150 to your general savings account per paycheck and $150 to your retirement savings account per paycheck. This separation of money keeps you from dipping your hands into savings and allows you to stay on track with a monthly budget.