Lecture 3 MANAGING YOUR CASH AND SAVINGS

© 2008 Thomson South-Western

Lecture 3

MANAGING YOUR CASH AND SAVINGS

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Role of Cash Management in Personal Financial Planning

i Cash management deals with the routine, day-to-day use of liquid assets.–Liquid assets consist of cash and

other assets that can be converted easily to cash with little or no loss in value.

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Examples of Liquid Assetsi Cashi Checking Accountsi Savings Accountsi Money Market Deposit Accountsi Money Market Mutual Fundsi U.S. Treasury Billsi EE Savings Bondsi Certificates of Deposit (shorter-

term)

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The Financial Services Marketplace

i Financial products– checking and

savings accounts– credit cards– loans and

mortgages– insurance– mutual funds

i Financial services– financial planning– tax preparation– brokerage services– real estate– trusts– retirement – estate planning

The financial services industry markets:

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Types of Financial Institutions

i Depositoryi Nondepository

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Types of Depository Financial Institutions

i Commercial Banks–Largest type of traditional

financial institution.–Offer full array of financial

services.–Only type of financial institution

that can offer noninterest-paying checking accounts.

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Savings and Loan Associations

–Offer many of the same services as commercial banks.

–Typically pay slightly more on savings deposits.

–Channel depositors’ savings into mortgage loans for purchasing and improving homes.

–Some are mutual associations.

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Savings Banks

–Similar to savings and loan associations.–Located primarily in New England states.–Offer interest-paying checking accounts.–Typically offer savings rates similar to

those of savings and loan associations.–Most are mutual associations.

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Credit Unions

– Provide financial products and services to specific groups of people who have a common tie.

– Qualified persons become members by purchasing a share of ownership.

– All are mutual associations; owned and sometimes operated by members.

– Typically pay interest rates higher than those of other financial institutions.

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Internet Banks

–Offer online banking services.–Feature lower fees and higher yields

than “brick-and-mortar banks.”–Suitable for people who do not need

to physically go to a bank.

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Types of Nondepository Financial Institutions

–Stockbrokerage firms—offer cash management accounts, money market mutual funds, wrap accounts, credit cards

–Mutual funds—offer money market mutual funds

–Life insurance companies–Finance companies

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How Safe is Your Money?

Almost all financial institutions are federally insured by either:

i Federal Deposit Insurance Corporation (FDIC) insures accounts at banks, savings banks, and S&Ls.

i National Credit Union Administration (NCUA) insures accounts at credit unions.

i Both provide government insurance up to $100,000 per depositor.

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Truth-in-Savings Act of 1993

i Helps consumers evaluate terms and costs of banking products.

i Fees, interest rates, and terms of both checking and savings accounts must be fully and clearly disclosed.

i Places strict controls on advertising and what constitutes a free account.

i Standard formula for annual percentage yield (APY) must used.

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Cash Management Products

With sufficient funds, banks must immediately pay the amount of your check or ATM withdrawal.

1. Checking Accounts =Demand Deposits

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i Funds are expected to remain on deposit for a longer time period than are demand deposits.

i Generally pay higher interest rates than demand deposits.

i At many institutions, the larger the balance, the higher the interest rate offered.

2. Savings Accounts = Time Deposits

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Types of Checking Accounts

i Regular checking accounts – Offered by commercial banks– Pay no interest

i Interest-bearing checking accounts– Examples include NOW, share draft,

and money market deposit accounts– Offered by banks, savings banks,

S&Ls, and credit unions

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– Offered by investment (mutual fund) companies

– Not federally insured; trade on open market

– Interest bearing; limited checks

Money Market Mutual Funds

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– Primarily offered by brokerage firms; consolidate financial activities

– Not covered by deposit insurance (protected by SIPC); open market

– Interest bearing; check writing privileges

Asset Management Accounts

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Other Money Management Services

i Electronic Banking Services

Electronic Funds Transfer Systems (EFTS) make possible– ATM service– Debit cards—linked to your checking

account– Pre-authorized deposits and payments– Banking by phone– Online banking and bill payment services

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–Regulates EFTS Services.

–States that errors must be reported within 60 days.

Electronic Funds Transfer Act of 1978

Limit your losses by immediately reporting theft, loss, or unauthorized use of your card or account!

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Other Bank Services

i Safe Deposit Boxesi Trust Services—provide

investment and estate planning advice and management for trust accounts.

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Maintaining a Checking Account

i Determine services needed.i Consider costs involved.i Keep track of checks written, automatic

deposits, and ATM withdrawals.i Don’t write checks for more than you

have in the account.i Arrange for overdraft protection.i Know how to stop a payment.i Reconcile your account monthly.

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Special Types of Checks

When personal checks are not accepted, special checks can be used to guarantee payment.

i Cashier’s—drawn on the bank.i Traveler’s—used for making

purchases worldwide.i Certified—drawn on your account but

guaranteed by the bank.

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Establishing A Savings Program

i PAY YOURSELF FIRST: On payday, write yourself a check and deposit it into a savings account, or transfer a set amount to savings through your debit card.

i Establish an emergency fund.i Regularly set aside funds for financial

goals.i Utilize direct deposits and automatic

transfers.i Choose instruments best suited to your

goals and time horizon.

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i Simple Interest—interest paid only on initial amount of deposit.

i Compound Interest—interest paid at set intervals and added back to principal.

Earning Interest on Your Money

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i Nominal rate—the named or stated rate of interest.

i Effective rate—the annual rate of return actually earned.

If interest is compounded more frequently than once a year, the effective rate will be greater than the nominal rate of interest.

Earning Interest on Your Money

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Effective rate = Annual amount of interest earned Amount of money invested

Example:Invest $1000 at 5% for 1 year.

How Is Interest Calculated?

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i If simple interest is used, there is no compounding:Interest = Principal x rate x time

= $1000 x .05 x 1= $50

How Is Interest Calculated?

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i If compound interest is used and the compounding occurs semiannually—First 6 months' interest:

$1000 x .05 x 6/12 = $25.00Second 6 months' interest: +

$1025 x .05 x 6/12 = $25.63Total annual interest = $50.63

How Is Interest Calculated?

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i The nominal rate is 5%, the stated rate of interest.

Effective Rate = $50.63 $1000 = 0.05063 = 5.063%

i The effective rate is 5.063%.

How Is Interest Calculated?

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Amount of interest earned depends oniFrequency of compoundingiBalance on which interest is paidiInterest rate applied

How Much Interest Will You Earn?

Time value of money concepts are used in compounding to find interest earned.

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A Variety of Ways to Save

i Certificates of Deposit (CDs) – Funds are to remain on account for a

given time period.– Early withdrawals incur an interest

penalty.

i U.S. Treasury Bills– Debt securities issued by the U.S.

Treasury.– Sold at a discount; $1000 minimum.– Mature in 1 year or less.

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A Variety of Ways to Save

i Series EE Bonds– Purchased at 1/2 face value.– Interest paid when bonds redeemed.– Newly purchased bonds must be held at

least 12 months; actual maturity date unspecified.

– Taxes not paid until bonds redeemed.– Exempt from state and local taxes.– If redeemed for educational purposes,

income taxes may be avoided.