Lesson 3 – Banking, Credit, and Debt

Introduction: Banking is central to our economy, and our personal finance, making it crucial that one develops a strong understanding of how banking works. In this section, you’ll learn about the different banking institutions and the services they offer, in addition to the importance of credit.

3.1 Types of Banking Institutions: 

While there are many options for conducting your banking, not all of them are created equally, each with their own pros and cons.

The most popular, and common, banking institutions are commercial banks. Commercial banks offer services such as savings and checking accounts and loans to consumers, business, and organizations alike. These institutions are backed by the Federal Deposit Insurance Corporation, or FDIC. The FDIC insures deposits of up to $250,000, and while it is a part of the US Government, is funded by dues from commercial banks. National bank chains such as Bank of America are examples of commercial banks.

Savings and Loan Institutions are similar to commercial banks, but focus the majority of their business on mortgages.

Another common banking institution is a credit union. Like a commercial bank, credit unions offer services like savings and checking accounts and loans. In contrast to commercial banks, which are typically owned by shareholders, credit unions are controlled by its members. Additionally, while commercial banks are open to all, credit unions are for those within a certain defined group. Many companies and geographical locations have credit unions. Because there is a strong customer connection to a credit union, fees and other charges are typically lower. Credit unions are not insured by the FDIC, but rather the National Credit Union Administration, which provides the same $250,000 insurance as a commercial bank. Here’s a great article with more information about credit unions.

A banking institution to avoid is a payday lender. These institutions typically prey on those with a poor credit history (more on that below), but also charge astronomical interest rates.

3.2 Types of Banking Services

The most commonly known banking services are savings accounts and checking accounts. In both accounts, one deposits money to the bank for safekeeping, and earns interest on the money deposited. In a checking account, one can take out money via checks, giving a checking account liquidity. In a savings account, what you can do with your money is limited, thus having a lower liquidity, but as a result the interest earned is higher. While savings accounts are typically available to all at little to no cost, checking accounts often have regulations and fees attached. For example, a bank may require you to have a certain amount of money in your account or deposit at least a certain amount every year to avoid a fee. Some banks may even charge you to open an account or take out money. Additionally, if you write a check or attempt to use a debit card for more than what is in your bank account, you’ll be charged an overdraft fee. Some banks offer overdraft protection, in which you’ll be protected from these fees if you accidentally overdraft your account, but it’s better that you’re always aware of your current account status. Wells Fargo has published a comprehensive list of the many fees you may find in a checking account. Because banks offer different accounts and fees, it’s important to consider your options.

Similar to a savings account is a money market account. These accounts require a higher minimum balance than a savings account, but also offer a higher interest rate. Additionally, a Certificate of Deposit, or CD, are similar to savings accounts but have less liquidity and higher interest rates. With a CD, you agree to give your money to the bank for a certain period of time, in exchange for a significantly higher interest rate than a savings account offers. If you want to take your money out of your CD while it is within the time-frame, you typically lose the interest earned and are subject to a fee.

Banks can also offer loans to individuals and companies, for things such as cars and company startup costs, in addition to mortgages, a fancy word for a loan to buy a house or building.

3.3 Interest

In this section we’ve mentioned the concept of interest frequently, so it’s important to get a good understanding of what it means. Below is a PowerPoint guide created by FBLA member Eric Lee of South Korea.

3.4 Credit

When considering offering a loan, banks need something to determine they likelihood of getting their money bank. The tool they use for this is a credit report, which is a detailed listing of one’s financial history. Within this report is a credit rating, which evaluates how creditworthy one is. There are three major credit rating firms in America: TransUnion, Experian, and Equifax. Because that’s a lot of information, a bank will usually refer to your FICO Credit Score, which summarizes this data in a numeric form ranging from 300 to 850. This score is made up of numerous factors, each valued differently. The breakdown is as follows:

Payment History (35%), Amounts Owed (30%), Length of Credit History (15%), New Credit (10%), and Credit Mix (10%)

The most important aspect of your score, is your history of payment. Lenders want to see that you’re paying, and paying on time. Next, is how much you currently owe. Together, these factors make up nearly two-thirds of your credit score. The longer your credit history is, the higher your score typically is. This is because you are more established, so the lender knows if you’re a safe (or unsafe) option, whereas with someone with new credit doesn’t have the same record, and thus is more risky. Finally, the mix of credit you use is taken into consideration. This looks at the blend of credit cards, mortgages, and loans you’ve used. FICO has a more detailed breakdown, which can be viewed here.

According to Experian, a score over 800 is exceptional, while anything above 739 is above average, and anything below 670 is below average. If you have a below average credit score, you’ll likely find it harder to get a loan, and end up having a higher interest rate from banks that do offer you a loan.

The United States Government requires the three credit rating agencies to allow you to obtain a free credit report once every twelve months, and you can do so here.

3.5 Forms of Purchasing

In the earliest days of civilization, people participated in the exchange of goods and services via barter, trading one good or service in exchange for another. Eventually, society advanced to have metal coins and paper money, creating currency. With the dawn of new technologies, forms of purchasing have evolved once again.

Today, most goods or services are purchased with cash, a debit card, or a credit card. In a few scenarios, mainly with major purchases, a check may be used. A debit card is essentially a more technologically advanced check. A debit card takes funds directly out of your bank account upon payment. A credit card, on the other hand, is similar to a loan. When you make a purchase with a credit card, your credit card company puts up the money up front. Then, at the end of the month, you pay your credit card company directly rather than each individual store. The risk with a credit card, is that you may end up spending more money than you have, and as a result incur heavy fees and interest rates for late payment. To entice consumers, credit card companies offer cash back and points for using their cards. Before getting a credit card, you should look at the benefits, fees, and annual percentage rate (APR), or interest rate, each card has. It’s important to keep in mind that purchases made with a debit card do not go towards your credit score, while purchases made with a credit card do go towards your credit score.

3.6 Bankruptcy

When you can no longer afford to meet your obligations to your lenders and debtors, you may file for bankruptcy. There are strict requirements in place to ensure that those filing are not attempting to swindle their creditors. There are two types of bankruptcy for individuals, Chapter 7, and Chapter 13.

Under Chapter 7 bankruptcy, all of your liquid assets, for example savings and checking accounts, are turned over to your creditors to repay a portion of your debt. Each state determines which specific assets may and may not be turned over. Under Chapter 7, you are getting rid of your debt obligations forever, but must be making under your state’s Chapter 7 income limit.

If you are over this limit, you must apply for Chapter 13 bankruptcy, which does not rid you of your debt obligations forever, but rather are attempting to make your debt payments more manageable by restructuring them or getting rid of some, but not all, of them. In essence, you’re creating a new plan to pay off your debt.

As expected, bankruptcy will cause your credit score to plummet, and should always be one’s last resort.

Conclusion: Effective banking creates new opportunities for earnings and growth, but on the flip side, poor spending habits and credit history and significantly impede your chances of buying a home or car.

Resources and External Links

Khan Academy – An In-Depth Look at Interest

Consumer Financial Protection Bureau – FAQs about Credit Scores

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