Banking, credit and debt

Key topic

In this lesson we present the basic banking operations that most closely relate to your future needs and discuss the different risks associated with credit, debit and credit history.  We will also be expanding on some of the information provided in Module 18- Savings and how to grow your money.

Learning objectives

• Understand the basic banking operations
• Understand the difference between debit and credit cards
• Learn what credit history is and its role in your financial life
• Discover the risks associated with bad loans and collaterals

The banking system in a nutshell

A bank is a financial institution that handles money, including keeping it for saving or commercial purposes, and exchanging, investing and supplying it for loans. Banks offer safe, secure, convenient services so you can save money and build a better financial future.

There are a number of reasons why people should put their money in a bank:

• Safety:  Storing money in a bank is much safer than holding cash. Deposits are also protected up to a certain amount by authorities such us the FDIC in the USA.
• Earning Capacity:  The bank pays interest every month just for depositing money, therefore any money put in a bank, creates more money.
• Convenience:  Most companies have your paycheck electronically deposited into their employees’ checking account so that they can make electronic payments for pretty much everything without having to physically go to the bank.
• Organization: Bank accounts help people track spending, manage savings, and stay on target with their budget.

How banks work

The banking concept is pretty simple: banks use your money – the money you and others save – to give loans to other bank account holders who want money to start a business or a buy a house and so on. What’s in it for you? You earn money through interest when you save money with the bank, like already discussed. Interest is what a bank pays you to save your money and is expressed as an annual percentage. For example, the bank may offer you an annual percentage of 2% for saving $10,000. That means that after 12 months you will have $10,200 in your account.

When other people borrow money, they are charged with an interest that is higher than the interest on deposits and the bank makes money from that interest (from the difference between the saving and lending rates) and its ability to use other people’s money. For example, if someone requests a loan of $10,000 to start their business and are charged a 5% (interest rate) then they will have to pay back $10,500. Those $500 are how the bank makes money; their profit.

Choosing a bank

When it is time to open a bank account, you should choose a bank that offers online banking because in today’s economy it is a feature you can’t do without.  With online banking, you can do transactions and check balances from wherever you are. You should also look at banking costs.  Banks have to be competitive which means that they should try and offer better services and rates than other banks, so it pays to compare fees for opening and running an account. There are often fees for both checking and savings accounts. The bank may also charge separate fees for such things as receiving bank statements in the mail, online banking and multiple checkbooks.  It is important to ask and compare all potential fees before settling on a particular bank. It is also important to use a bank that’s convenient in terms of location and it is equally important to check out the convenience of ATM locations. If for example, you are from California but there are better banks in New York, it still doesn’t make sense to go with a bank in New York because you will not have access.

Remember that you want to build a long-term relationship with the bank you choose. You’ll find that, the longer you remain a good customer, the more benefits you’ll receive.

Checking and savings accounts

There are several different types of accounts you can open at a bank. At the minimum, people should have a checking account and a savings account. A checking account is where most of your transactions will take place.  A checking account is your banking hub and will handle most of your financial transactions. There you will have the money you need for daily use, to buy your coffee, to pay for a meal and so on. Usually checking accounts do not pay any interest.

A savings account pays interest on the money you have on deposit.  Savings accounts are used for your emergency fund, your short-term fun fund and your long-term investment fund, as discussed in a previous lesson.

This is the first step to getting finances in order.  Savings and checking accounts can be linked, so that money can be transferred between accounts with ease.  Ideally, the accounts should be set up so that a fixed portion of money is automatically transferred each month from checking to savings. That way saving money becomes easy and automatic. Plus, all your accounts can be monitored smoothly. It’s important to have a good understanding of your account balances, so you know how much money you have available to spend at any time and it should be in line with your monthly budget.

Let’s watch a 2-minute video on how to manage your first bank account:

Manage your first bank account

Debit vs credit cards

There are two different types of cards issued by banks. In the case of a debit card, the bottom line is that transactions happen with the use of your money. Your debit card charge will be deducted from your bank balance as an outflow without creating any liability- obligation from your side- towards the bank. Basically, a debit card is the alternative to carrying cash. It’s a plastic card you use that represents the checking account we talked about before. The characteristics of a debit card are that it is linked to a bank account, that the money available for use is equal only to the available amount in your account and that after the transaction this money is automatically added or removed from your account.

Credit cards on the other hand, utilize the bank’s money for a transaction, which automatically creates a liability, an obligation from your side towards the bank. It is like having money available from the bank, which is not yours, in the form of a small loan that you have to repay with interest every month. Credit cards have different characteristics than debit cards.

Credit card usage leads to a type of a loan from a bank to your family, which helps the bank make money from interest and fees charged to you in the same way that we previously explained with loans – using a percentage – especially if you don’t repay what you owe to the bank in full or you are constantly late with your payments. However, if you are educated on the credit system and are on time with monthly payments, you can utilize the offers provided from credit cards and their associated organizations, in saving money and reducing costs of other purchases (for example airplane tickets, amusement parks entrance fees etc). It should also be noted that generally credit cards tend to offer greater protection in case of theft.

As we will discuss in the next part of this lesson, the fees and interest rates on your credit card are directly associated with credit history, which is your past record of paying bills and handling credit.

Credit cards are convenient, most businesses accept them and they’re easier to carry than cash. Credit cards can be a handy tool for your purchases as long as you pay the bills in full each month and avoid paying large interest fees.  However, when faced with an emotional or impulse purchase, pulling out the plastic can be far too easy to do. If money is tight, it’s easy to talk yourself into thinking “charging it” is no big deal. But if you don’t take spending seriously, receiving that credit card bill can be a painful experience.

The best way to manage a credit card is to repay it in full on a monthly basis. Credit card companies make their money when customers carry a balance from month to month, therefore you will need to plan and budget your purchases properly so you can pay your credit card bills in full each month.  You may think it’s okay to pay just the minimum payment the credit card company calculates for you. That’s a common misunderstanding.  In fact, the minimum payment just represents the minimum amount that will keep your account active. It’s not enough to pay off the debt in a reasonable timeframe.

You should be aware that as you build your credit status, credit card offers will begin flooding your mailbox. Credit card offers vary a lot, so read the terms and conditions carefully. Just because they send you a “pre- approved” application with a huge credit limit doesn’t mean you should apply, much less consider this money offered as available for your financial plan.

We will watch a 3-minute video on the differences between debit cards and credit cards and how teenagers should use them.

Debit vs Credit cards

Credit history

Credit, is an arrangement that postpones payment for borrowed money or a purchased item until later. In other words, you get money or stuff now, and you agree to pay it back later. When you buy or borrow on credit, you generally end up paying back more than the original amount in interest. For example, if you a buy a pair of shoes for $100, you might end up paying $120 for them. How much interest you pay depends on your credit history, which is your record of paying bills and handling credit in the past. The percentage of the debt that you’re charged on top of the original amount is called interest and it is determined by the interest rate.  Learning how credit works is the key to building a good credit history.

Credit refers to your ability to borrow money to pay for something. Such borrowed money also includes credit cards. Credit is used to buy cars, houses, and major appliances. Simply defined, good credit means you keep all your financial agreements in good faith; you honor your commitments and pay all your bills on time. Your credit score is similar to a report card in school; it will open doors if it’s high but it will have the opposite result if it’s low.  If you don’t pay your bills on time, if you carry a high debt load, and have bills that you stopped paying, you probably will have a bad credit score.

Your credit history, or credit report, is a detailed account of all information about your credit situation: how much you owe, how you pay your bills, and whether your payments have ever been late. Credit agencies track and analyze this information to calculate your credit score. Credit scores are expressed in numbers between 300 and 850; the higher your score, the better your credit.

The key point to be made here is that you should strive to have the highest possible credit score. Not only it will imply that you have managed to stay safe from financial hardships, it will also mean that, if necessary, you can fall back on it and use this good credit score to help you.

We will now watch a short video on building your credit at a young age.

Build Credit at a young age

Good debt vs bad debt

There are two types of debt, the so called “good debt” and “bad debt”. It is easily assumed that good debt is highly preferred over bad debt, because on top of everything else, you need good debt to have a positive credit history.

Good debt is the kind we use to buy assets. The goal of good debt is to purchase items that will eventually lead to asset value being increased. Bad debt refers to loans that you take out to purchase consumable items such as going to an expensive restaurant or items whose value decreases over time, such as fancy cars. Good or bad debt, people should make it a point to take out loans and carry debt within the overall capabilities of their budget. Even loans used to purchase good investments can lead to financial problems, if you don’t handle them properly.

Examples of good debt are:

• Investment Loans, which produce income
• Loans for Real Estate, if the property you buy produces an income, which in turn can help repay the loan and create added financial value. For example, if you buy an apartment and rent it out to someone else which leads to a steady flow of income every month
• Business loans for creating or expanding a business
• Education loans. Given that the average income of a university graduate far exceeds that of those without higher education, these can be considered as an investment.
• Home Loans for a property you live in – Purchasing a home may be a good investment because instead of paying rent, your payment goes towards the mortgage and the house will end up being yours after you have repaid the loan.

Examples of bad debt include the following:

• Credit Card debt, due to the high interest rates and fees. A credit card can be good debt, only if you pay the money you borrowed, back in full each month; that helps increase your credit score and you incur no interest charges
• Personal/Consumer Loans or Bank overdrafts, which also carry high interest rates and they usually finance the “want” rather than the “need”

It is important that you learn how this system works and prepare to manage debt.

Loans and collateral

A loan is a sum of money that you borrow now and which you can repay in the future with interest. Remember our example from the first part of this lesson.  A lender is a person or organization that lends money.  Sometimes the lender may ask you for collateral, so that risk is minimized. Collateral is something that the lender demands in order to feel safe. For example, if you want to buy a vacation house by the beach and need a loan to do it, the lender may demand your home as collateral. Collateral is something that can be used as security for a loan. If you do not repay the loan, the lender keeps your collateral; in this case, your vacation home. In the world of financial management, risk refers to the possibility of financial loss. Lenders estimate the value of your collateral to reduce their risk. There are high-risk loans, and there are low-risk loans.

Lenders look at the overall picture to determine whether you qualify for a loan. They want to see that you are not high-risk. A high-risk applicant is one whose financial situation indicates that they would have trouble repaying a loan. If for example you make $60,000 a year and want to buy a mansion that costs $5,000,000 you will be high risk, since it will be unlikely that you’ll be able to make the monthly payments. Credit and the ability to repay the loan, are a few of the things a potential lender will look at to qualify a loan applicant.

Action Steps – Exercise 1 (10 minutes)

Please answer the following questions:

1.Please choose all that apply: Some of the advantages of storing your money in a bank are:

1. You can spend more than you actually have
2. Earning capacity
3. Safety
4. Convenience

2. One of the differences between a checking and savings account is that with a saving account the bank will pay you for saving your money there.

1. True
2. False

3. Please fill in the blanks. _________ usage leads to a type of a loan from a bank to you, which helps the bank make money off of you from interest and fees.

1. Loan card
2. Debit card
3. Credit card
4. Gift card

4. Please choose all that apply. Examples of “good debt” are:

1. Loans for expanding your business
2. Credit card debt
3. Consumer loans
4. Loans for real estate

5. Calculate the following: You go to a bank to save $100 and the bank offers you an annual interest rate of 20% for saving your money there. How much will you have in your saving account after one year?

1. $20
2. $120
3. $200
4. $100

Answer sheet:

Lesson wrap-up

Today we discussed the several things in relation to the banking system.  We went over savings and checking accounts and explained the differences, before moving to debit and credit cards and their differences. We then briefly outlined what credit history means and its importance when it comes to your financial status, especially If you want to take out a loan. The next thing we looked at was debt – good and bad – and gave some examples.  Finally, we discussed loans and collateral.

At this point we will wrap up today’s lesson.  First, we will go over the learning objectives of this lesson and we want your feedback as to whether they have been achieved and then we will address any questions you may have.  Please feel free to ask anything you’d like in relation to today’s lesson and we would love to hear how the concepts we discussed today relate to you and your life!