U2: your own money: savings
So I'm savings accounts need to be
"Segregated" because of different tax consequences Dash retirement or education accounts, for example
You can calculate the eventual value of your account by using the relationships of time in value. That is:
(1+r)^t
Annual percentage rate
(APR) the rate at which your principal compounds that your account earns
When incomes are larger than expenses, there is
A budget surplus, and that surplus can be saved
Some checking accounts do earn some interest, but often require
A minimum balance
However, interest rates change, and banks with savings plans that offer higher yields often require
A minimum deposit, minimum balance, and/or a maintenance fee
For the borrowers, the bank can create
A steady supply of surplus money for the loans (from the lenders), and arrange standard loan terms for the borrowers
If you do not withdraw the interest from your account, it is
Added to your principal balance, and you earn interest on both. This is referred to as earning interest on interest, or compounding
You give up more liquidity when you
Agree to commit to a minimum time or amount of money to save or lend
Intermediation allows for the
Amount loaned or borrowed to be flexible and for the maturity of the loans to vary. That is, you don't have to land exactly the amount someone wants to borrow for exactly the time she or he wants to borrow it
The bank functions as
An intermediary or "middleman" between the individual lender of the money ( the saver) and the individual borrower of money
Since the financial crisis of 2007 to 2009, bank money market funds also
Are insured
Most individuals are less willing to
Assume opportunity costs and risks when it comes to consumption, thus limiting the time that they are willing to earn liquidity
For most individuals, access to the money markets is done through a
Bank
To finance consumption, however, most individuals primarily use
Banks
You do not want to give up too much liquidity and then risk being caught short
Because then you will have to become a borrower and make up the shortfall, which will create additional costs
If you were using CDs, the strategy is called
CD laddering
If you were willing to give up more liquidity,
Certificates of deposit (CDs) offer a higher price for liquidity but extract a time commitment and forced by penalty for early withdrawal.
Your expectations of interest rates will
Contribute to your decision to give up liquidity
Certificates of deposit are offered for
Different maturities, which are typically from six months to five years, and have some minimum deposits as well
The different time horizons and risk tolerance is of the buyers, and especially the sellers, in each market create
Different ways of trading or packaging liquidity
By having many lenders and many borrowers, the bank
Diversifies the supply of and demand for money, and this lowers the overall risk in the money market
One strategy to maximize liquidity is to
Diversify your savings in a series of instruments with differing maturities
The laddering strategy is an example of how
Diversifying maturities can maximize both earnings and liquidity
In choosing an intermediary, savers should make sure that accounts are
FDIC or NCUA insured
Since the bank failures of the great depression, bank deposits are
Federally insured (Up to $250,000) through the FDIC (Federal deposit insurance corporation)
If your liquidity needs are more predictable or longer-term, you can
Give up liquidity without creating unnecessary risk and can therefore take advantage of products, such as CDs, that will pay a higher price
Retail banks
Have focused on consumer saving and borrowing
Commercial banks
Have focused on operating cash flow management for businesses
If you expect interest rates rise, you will want to
Invest in shorter term maturity's, so as to regain your liquidity in time to reinvest at higher rates
If you cannot predict your liquidity needs or you know they are immediate, you should choose products that will
Least restrict your liquidity choices
Because money trade in markets and liquidity has value, your alternative is to
Lend that liquidity to someone who wants it more than you do at the moment and is willing to pay for its use
Checking accounts that do not earn interest are
Less useful for savings and therefore more useful for cash management
If you expect interest rates to fall you would want to invest in
Longer-term maturity so as to maximize your earnings for as long as possible before having to re-invest at lower rates
A "laddering" strategy allows you to
Maximize return and liquidity by investing $1000 per month by buying a one-year CD. After 12 months, all your savings is invested in 12 CDs, each earning 1.5%. Because the CD matures each month, you have $1000 worth of liquidity each month. You can keep the strategy going by reinvesting each CD as it matures
Time deposits, or savings accounts, offer
Minimal interest or a bit more interest with minimum deposit requirements
The bank can also expertise in screening borrowers to
Minimize risk and in managing and collecting the loan payments. Intern, that reduced risk allows the bank to attract lenders and diversify supply
The markets for liquidity are referred to as the
Money markets in the capital markets
Well the borrower has more opportunity, you (the seller) have
More opportunity cost because you give up more choices over a longer period of time. That also creates more risk for you, since more can happen over a longer period of time
For the Savior, a demand deposit (e.g., checking account) typically earns
No or very low interest but also complete liquidity on demand
In most cases, however, separating accounts by their intended use has
No real financial value, although it can create a psychological benefit
For the saver or lender, the bank can
Offer the convenience of finding and screening the borrowers, and of managing the loan repayments
Ideally, you would choose a bank savings instrument that
Offers the highest APR and most frequent compounding
They are cost advantages for the bank if it can use
Online technologies in processing saving and lending. Those cost savings can be passed along to savers in the form of higher returns on savings accounts or lower service fees
Money sitting idle is an
Opportunity cost
In addition to banks, other kinds of intermediaries for savers include
Pension funds, life insurance companies, and investment funds. They focus on saving for a particular long-term goal.
Banks offer many different ways to save your money until you use it for consumption. The primary difference among the accounts offered to you is the
Price that your liquidity earns, or the compensation for your opportunity cost and risk, which intern depends on the degree of liquidity that you were willing to give up
You can use the annuity relationships to
Project how much the account will be worth at any point in time, given the rate at which compounds
Banks serve to
Provide the consumer with excess cash by having the cash earn money through savings until the consumer needs it
A laddering strategy can also
Reflect expectations of interest rates
One saving strategy is to create
Regular deposits into a separate account that you might have a checking account from which you pay living expenses and a savings account in which you save. This is easier with direct deposit of wages, since you can have a portion of your disposable income go directly into your savings account. Saving becomes effortless, while spending actually requires a more conscious effort
Because their roles as intermediaries is critical to the flow of funds, banks are
Regulated by federal and state governments
The capital markets are used for
Relatively long-term, higher risk trading of money
The money markets are used for
Relatively short term, low risk trading of money
Since they create value in the market (by lowering costs), banks
Remain as intermediaries or middleman in the money markets
In order to save it all, however, you have to choose to
Save income that could otherwise be sent, suffering the opportunity cost of everything that you could've had instead
Consumers use retail institutions, including the following
Savings banks Mutual savings banks Savings and loan associations Credit unions
Treasury bills
Short term government debt
Credit union accounts are
Similarly insured by the national credit union agency or NCUA, also an independent federal agency
Credit unions function
Similarly to retail banks, but are cooperative membership organizations, with depositors as members
The price that you can get for your money has to do with
Supply and demand for liquidity in the market, which in turn has to do with a host of other macro economic factors
The time until you withdraw your funds is
T
Your interest from savings is
Taxable, as it is considered income
When individuals are saving or investing for a long-term goal (e.g., education or retirement) they are more likely to use
The capital markets; Their longer time horizon allows for greater use of risk to earn return
The longer you lend your liquidity,
The more compensation you need for your increased opportunity cost and risk
Retail banks are commonly known as
Thrift institutions, saving banks, savings and loan associations, or mutual savings banks and are usually private or public corporations
Savings products versus liquidity and risk
Time commitment- less: checking, savings, MMMS; more: CDs Risk - less: checking, savings, CDs; more: MMMS Interest earned - less: checking, savings; more: MMMFs, CDs
Saving to finance consumption relies more on
Trading liquidity in the money markets, because there is usually a shorter horizon for the use of the money
Compared to the capital markets, the money markets have
Very little risk, so MMMF's are considered very low risk investments
Establishing a savings vehicle has a
Very low cost, if any, so it is easy to establish as many separate funds for saving as you find useful
If you expect interest rates to fall, you would want to
Weight you laddering strategy to longer-term CDs, keeping only your minimum liquidity requirement in the shorter term CDs
You could keep the budget surplus in your position and store it for future use, but then
You have the burden of protecting it from theft or damage. More importantly, you can create an opportunity cost
As you can imagine, however, with monthly automatic deposits into a savings account with the compounding interest, you can see
Your wealth can grow safely
Banks can also offer investments in money market mutual funds (MMMF's), which offer
a higher price for liquidity because your money is put use in slightly higher risk investments, such as treasury bills (short term government debt) and commercial paper (short term corporate debt)
Some intermediaries have moved away from the
"Bricks and mortar" branch model and no operators online banks, either entirely or in part
The bank can
"Disconnect" the lender and the borrower, creating that flexibility
If you were depositing a certain amount each month or with each paycheck, that stream of cash flows is an
Annuity
When you use someone else's money or when you borrow, you are the
Buyer of the liquidity
Savings instruments include the following
Demand deposit accounts Time deposit accounts Certificates of deposit Money market mutual fund accounts
If you believe that interest rates were the earnings on your money will increase, then you
Don't want to commit to the currently offered rates for too long. Your laddering strategy may involve a series of relatively short term (less than one year) instruments
Investment banks
Have focused on long-term financing for businesses
Your choice of savings instrument should reflect your
Liquidity needs
Through diversification and expertise, banks ultimately
Lower the cost of lending and borrowing liquidity
A savings strategy can
Maximize your earnings from savings
If you are willing to lend your liquidity for a long time, then the borrower has
More possible uses for it, and increased mobility increases its value
The balance in your account today is your
Present value (PV)
Your future value depends on the
Rate at which you can earn a return or the rate of compounding for your present account
The APR is your
Rate of compounding, r
In the money market, all such instruments are
Relatively low risk, so return will be determined by opportunity cost
When you save, you are the
Seller or lender of liquidity
Commercial paper
Short term corporate debt
The price that you can get for your money also has a lot to do with
Time, opportunity cost, and risk
As long as money remains in your account, including any interest earned while it is there,
You can earn interest on that money