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Chapter 4 Managing Your Cash and Savings Learning Objectives LO1 Understand the role of cash management in the personal financial planning process. LO2 Describe today’s financial services marketplace, both depository and no depository financial institutions. LO3 Select the checking, savings, electronic banking, and other bank services that meet your needs. LO4 Open and use a checking account. LO5 Calculate the interest earned on your money using compound interest and future value techniques. LO6 Develop a cash management strategy that incorporates a variety of savings plans. Major Topics This chapter is concerned with cash management, which involves making sure that adequate funds are available for meeting both planned and unplanned expenditures and that spending patterns are in line with budgetary guidelines. Cash management is an important aspect of personal financial planning; it ensures that adequate funds are available for paying bills and that an effective savings program is established and implemented. This process begins with an understanding of the financial marketplace, which includes a tremendous variety of institutions providing numerous account and transaction services. Financial institutions provide checking facilities that allow transactions to be made safely and efficiently. The methods of accessing accounts vary greatly with the technology that is available. They also make available numerous savings vehicles that can be used to earn a return on temporarily idle funds. In addition, a variety of other ways to save are also available from the government and brokerage firms. The major topics are included in the Power Point slides available to the instructor and are identified below as they relate to the learning goals for the chapter. Learning Goals LG1 Understand the role of cash management in the personal financial planning process. In personal financial planning, efficient cash management ensures adequate funds for both household use and an effective savings program. Exhibit 4.1 lists the various cash accounts and their related representative rates of return. In 2018, the Fed plans to raise interest rates, thus the rates in the exhibit will most likely change. But, the relation between the alternative accounts will stay the same. In addition students need to understand the importance of keeping a record of their deposits and expenditures from their cash accounts. LG2 Describe today’s financial services marketplace, both depository and nondepository financial institutions. Exhibit 4.2 will provide the focus for this section. Use it. A second point is the role of the FDIC and other deposit insurance or lack of insurance reported in Exhibit 4.3.. LG3 Select the checking, savings, electronic banking, and other bank services that meet your needs. I suggest that you go to a local bank web page and copy the various plans they have for classroom discussion. Exhibit 4.4 lists the normal types of bank charges and can be used, but a local bank’s services and fees will be more relevant to the student. LG4 Open and use a checking account. I think sections 4a and 4b cover this material well and class time is not needed. The importance of the monthly bank reconciliation should be noted. If the students try to get by with a quarterly or longer reconciliation, the checking account records will contain so many errors and mistakes that there will be no information in the check register. The account will be out of control. A monthly bank reconciliation is required to keep control of the bank account. LG5 Calculate the interest earned on your money using compound interest and future value techniques. Exhibit 4.6 presents the “magic of compounding”, a listing of rates that may apply to checking accounts. LG6 Develop a cash management strategy that incorporates a variety of savings plans. The importance of an emergency fund [6 to 9 months of take home pay] and liquid assets equally 10% of your investment portfolio needs to be emphasized. While both involves liquid assets, their purposes are different. Emergency funds are for the unexpected need for funds due to a loss of a job, unexpected medical expenses, car accidence, major car repair, and others. The need for liquid assets in your portfolio is to provide flexibility to your investments and to provide the ability to readjust the mix of your portfolio. The ability of the automatic deposit or transfer from checking to savings makes a systematic saving plan possible. If you never have you hands on the money, you cannot spend it. That’s makes saving easier. Money market accounts, which pay slightly higher rates than saving accounts, are available from banks and investment firms. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. Financial Fact or Fantasy? 1. An asset is considered liquid only if it is held in the form of cash. Fantasy: A liquid asset is one that is held in cash or can be readily converted to cash with little or no loss in value. Thus, liquid assets include checking accounts, savings accounts, money market accounts and funds, and other short-term investment vehicles. 2. Today’s financial marketplace offers consumers a full range of financial products and services, many times all under one roof. Fact: The financial marketplace offers financial products such as checking and savings accounts, credit cards, loans and mortgages, insurance, and mutual funds, and financial services concerned with financial planning, taxes, real estate, trusts, retirement, and estate planning. Such products and services are offered by banks and savings institutions, insurance companies, brokerage firms, mutual funds, and even nonfinancial companies like Kroger and General Motors. 3. Unlike money market mutual funds, money market deposit accounts are federally insured. Fact: Money market deposit accounts are funds deposited in special, high-paying savings accounts at banks, S&Ls, and other depository institutions and thus are covered by the same federal deposit insurance as any other checking or savings account. Money market mutual funds don’t have this coverage. 4. At most banks and other depository institutions, you will be hit with a hefty service charge if your checking account balance falls even just $1 below the stipulated minimum amount for just one day out of the month. Fact: Many depository institutions use the daily balance in your account, rather than the average monthly balance, to determine whether you must pay a service charge. Thus, letting it fall below the minimum even once can have a significant cost 5. U.S. Series EE and I savings bonds are not a very good way to save. Fantasy: Investing in Series EE and I savings bonds are excellent ways to save. The bonds are safe because they are backed by the U.S. government, offer market rates of return, and offer several attractive features. Series I bonds are particularly attractive to those wanting protection against inflation. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False An asset is considered liquid only if it is held in the form of cash. 2. True False Today’s financial marketplace offers consumers a full range of financial products and services, many times all under one roof. 3. True False Unlike money market mutual funds, money market deposit accounts are federally insured. 4. True False At most banks and other depository institutions, you will be hit with a hefty service charge if your checking account balance falls even just $1 below the stipulated minimum amount for just one day out of the month. 5. True False U.S. Series EE and I savings bonds are not a very good way to save. Answers: 1. False 2. True 3. True 4. True 5. False Rule of 72 The rule says that to find the number of years required to double your money at a given interest rate, you just divide the interest rate into 72. For example, if you want to know how long it will take to double your money at eight percent interest, divide 8 into 72 and get 9 years. Financial Planning Exercises The following are solutions to the financial planning exercises at the end of the PFIN 7 textbook chapter. 1. Adapting to a low interest rate environment. A retired couple has expressed concern about the really low interest rates they’re earning on their savings. They’ve been approached by an adviser who says he has a “sure-fire” way to get them higher returns. What would you tell this retired couple about the low-interest-rate environment, and how would you recommend them to view the adviser’s new prospective investments? While it is true that low interest rates will result in reduced income to retirees, the search for higher current returns has led many individuals to make investments of questionable risk. You probably would be best to urge your parents to be very skeptical of “sure-fire” claims for higher returns. If something sounds too good to be true, then it probably is not true. The couple should develop a portfolio that includes investments in higher-quality corporate bonds, high dividend paying stocks [such as utilities and smaller banks], and money market accounts. Returns for bonds typically go up as interest rates go down and alternatively go down as interest rates go up. Conversely, more moderate strategies for older investors would be to invest in stocks that typically pay high dividends. Temper your advice by letting them know that stocks are generally riskier than bonds, so the higher risk is an important consideration. Rates tend to go up and do down. Patience is good. 2. Comparing banks online. What type of bank serves your needs best? Visit the Internet sites of the following institutions and prepare a chart comparing the services offered, such as traditional and online banking, investment services, and personal financial advice. Which one would you choose to patronize, and why? a. Wells Fargo (—a nationwide, full-service bank b. A leading, local commercial bank in your area c. A local savings institution d. A local credit union The assumption is that “you” in the problem is a college student. So the table should compare accounts designed for college students. Below is a chart copied after Exhibit 4.4 in the chapter.
Features Wells Fargo Student Checking Account [Everyday checking account] Local bank Savings Bank Credit Union
Minimum daily balance for fee waiver $1,500, direct deposit of $500,
Monthly service fee $10, no fee for ages 17 – 24 or 10 or more debit card transactions. Or a linked Wells Fargo Campus ATM or Campus Debit Card (for college students)
Interest No
Online statements Yes
Online bill payment Yes
Monthly check return No, images of checks available online, no fee
Free Checks No
Overdraft protection Yes, with fee
ATM and check card Yes, $2.50 fee for non-Wells Fargo
3. Choosing a new bank. You’re getting married and believe your present bank is not a good fit. Discuss how you should go about choosing a new bank and opening an account. Consider the factors that are important to you in selecting a bank—such as the type and ownership of new accounts and bank fees and charges. Students’ answers will vary but should discuss the following aspects of bank and account choice: •Individual or joint accounts and why selected •Convenience factors that are important (e.g., what hours, locations are required) •Desired services, where available, and fees charged for them •Type of account charge (monthly fees or minimum balance) and why selected Newly married couples need to discuss whether to have a joint account or separate accounts. If one spouse is going to manage the couple’s money, then a joint account is best. If each wants to manage their own money, then separate accounts are appropriate. Most couples use joint accounts with the checkbook either at home or in the hands of the one who writes the most checks. Having two separate checkbooks can work, but it is hard to keep track of the correct balance in the account. Choosing a new bank is an important decision, especially when you're getting married and merging finances. Here's how you can go about selecting a new bank and opening an account: 1. Determine Your Needs and Preferences: • Consider what's important to you in a bank. This could include factors like account types, fees, convenience, customer service, and additional services like mobile banking or ATM access. 2. Research Potential Banks: • Look into different banks and credit unions to find the best fit for your needs. • Consider factors such as: • Types of accounts offered (checking, savings, money market, etc.). • Account fees and minimum balance requirements. • ATM access and fees. • Online and mobile banking options. • Interest rates on savings accounts. • Customer service reputation. 3. Compare Account Options: • Compare the types of accounts offered by different banks and the associated fees and features. • Consider whether you want joint accounts, individual accounts, or a combination of both. 4. Visit Branches and Speak with Representatives: • Visit the branches of the banks you're considering. • Speak with representatives to get more information about their services and to ask any questions you may have. 5. Consider Account Ownership: • Decide whether you want individual accounts, joint accounts, or a combination of both. • If you're merging finances with your spouse, joint accounts may be a good option for shared expenses, while individual accounts can offer financial independence. 6. Evaluate Fees and Charges: • Pay close attention to account fees, including monthly maintenance fees, ATM fees, overdraft fees, and any other charges. • Choose a bank that offers accounts with low or no fees, or one that offers fee waivers based on certain criteria (e.g., maintaining a minimum balance). 7. Open Your Account: • Once you've chosen a bank, visit the branch or open an account online. • Gather the necessary documents, which may include identification, proof of address, and your Social Security number. • Complete the account opening process, and deposit any required opening funds. 8. Transfer Funds and Set Up Direct Deposits: • Transfer any funds from your old bank to your new account. • Set up direct deposits for any recurring income, such as paychecks. By following these steps, you can select a new bank that meets your financial needs and preferences and smoothly transition your accounts to your new banking institution. 4. Exposure from stolen ATM card. Suppose that someone stole your ATM card and withdrew $1,000 from your checking account. How much money could you lose (according to federal legislation) if you reported the stolen card to the bank: (a) the day the card was stolen, (b) 6 days after the theft, (c) 65 days after receiving your periodic statement? If your ATM card was stolen and $1,000 was withdrawn from your checking account, you would be liable for: a. $50 if you notified the bank within two business days; b. $500 if you fail to notified the bank within two business days; and c. $1,000 (or all the money in your account, whichever is greater) if you waited 60 days after receiving your statement to notify the bank. Some states provide even greater protection for debit card users, as do various banking institutions. Also, home owners insurance may provide some protection. Certainly quick action when a card is lost is beneficial to the card holder. 5. Calculating the net costs of checking accounts. Determine the annual net cost of these checking accounts: a. Monthly fee $4, check-processing fee of 20 cents, average of 23 checks written per month b. Annual interest of 1.5 percent paid if balance exceeds $750, $8 monthly fee if account falls below minimum balance, average monthly balance $815, account falls below $750 during four months. Obviously, the b option is less costly due to the no fee during months with a minimum balance of $750. 6. Checking account reconciliation. Use Worksheet 4.1. Mateo Gonzalez has an interest-paying (NOW) checking account at the First State Bank. His checkbook ledger lists the following checks:
Check Num Amount Check Num Amount Check Num Amount
654 206.25 672 24.90 678 38.04
658 55.22 673 32.45 679 97.99
662 103.00 674 44.50 680 486.70
668 99.00 675 30.00 681 43.50
670 6.10 676 30.00 682 75.00
671 50.25 677 111.23 683 98.50
Mateo also made the following withdrawals and deposits at an ATM near his home:
Date Amount Transaction Date Amount Transaction
11/1 $50.00 Withdrawal 11/21 $525.60 Deposit
11/2 $525.60 Deposit 11/24 $150.00 Withdrawal
11/6 $100.00 Deposit 11/27 $225.00 Withdrawal
11/14 $75.00 Withdrawal 11/30 $400.00 Deposit
Mateo’s checkbook ledger shows an ending balance of $286.54. He has just received his bank statement for the month of November. It shows an ending balance of $614.44; it also shows that he earned interest for November of $3.28, had a check service charge of $8 for the month, and had another $20 charge for a returned check. His bank statement indicates the following checks have cleared: 654, 662, 672, 674, 675, 676, 677, 678, 679, and 681. ATM withdrawals on 11/1 and 11/14 and deposits on 11/2 and 11/6 have cleared; no other checks or ATM activities are listed on his statement, so anything remaining should be treated as outstanding. Use a checking account reconciliation form like the one in Worksheet 4.1 to reconcile Mateo’s checking account. 6. Worksheet 4.1 is below. 7. Calculating interest earned and future value of savings account. If you put $6,000 in a savings account that pays interest at the rate of 3 percent, compounded annually, how much will you have in five years? (Hin Use the future value formula.) How much interest will you earn during the five years? If you put $6,000 each year into a savings account that pays interest at the rate of 4 percent a year, how much would you have after five years? You can use the formula FV = PV × (1 + i)n if table is not available. Factor from the table in Appendix A for 3% interest for 5 years is 1.159 Using the financial calculator, set on END MODE and 1 P/YR: Since you initially deposit $6,000 and end up with $6,955.64 in five years, the amount of interest earned is the difference, or $955.64. Calculate the future value of a series of yearly $6,000 payments compounding at 4% per year using the financial calculator, set on END MODE and 1 P/YR: Using the Appendix B, the future value of an annuity of $6,000 per year with 4% interest is 5.416. Thus, future value is $6,000 * 5.416 = $32,496. If you are using Excel, you use the FV formula as follows: fv(.04,5,6000) Answer is $32,497.94. 8. Determining the right amount of short term, liquid investments. Ella and Aaron Martin together earn approximately $92,000 a year after taxes. Through an inheritance and some wise investing, they also have an investment portfolio with a value of almost $200,000. a. How much of their annual income do you recommend the Martins hold in some form of liquid savings as reserves? Explain. b. How much of their investment portfolio do you recommend they hold in savings and other short-term investment vehicles? Explain. c. How much, in total, should they hold in short-term liquid assets? a. Since Ella and Aaron Martin have annual after-tax income of $92,000, their monthly after-tax income is $7,666.67 (i.e., $92,000/12). There is general consensus that most families should have from six to nine month's after-tax income as liquid reserves. Ella and Aaron should hold from $46,000 (i.e. 6 * $7,666.67) to $69,000 (i.e. 9 * 7,666.67) in some form of liquid savings as reserve. b. The general rule is that 10% to 25% of one's investment portfolio should be held in savings and short-term investment vehicles. For the Hudgins, this amount would be between $20,000 and $50,000 (i.e., 10% × $200,000 and 25% × $200,000). c. In total, their short-term liquid asset position should be the sum of their liquid reserves (calculated in (a) above) and their short-term investments (calculated in (b) above). This amount totals between $66,000 (i.e., $46,000 + $20,000) and $119,000 (i.e., $69,000 + $50,000). However, the longer their investment time frame the less short-term investments are needed in the investment portfolio, particularly with adequate liquid reserves as described in part a. 9. Short-term investments and inflation. Describe some of the short-term investments that can be used to manage your cash resources. What factors would you focus on if you were concerned that inflation will increase significantly in the future? Short-term investment vehicles include savings accounts, money market deposit accounts, money market mutual funds, NOW accounts, CDs, U.S. Treasury bills, Series EE bonds, I Savings bonds, and asset management accounts. T-bills are almost as liquid as cash because they can be sold at any time. Series EE savings bonds earn interest at a fixed rate for 30 years. Their long life lets investors use them for truly long-term goals like education and retirement. The higher the rate of interest being paid, the shorter the time it takes for the bond to accrue from its discounted purchase price to its maturity value. Bonds can be redeemed any time after the first 12 months, although redeeming EE bonds in less than 5 years results in a penalty of the last 3 months of interest earned. The interest rate is set every 6 months in May and November and changes with prevailing Treasury security market yields. EE bonds increase in value every month and the stipulated interest rate is compounded semiannually. I Savings bonds should be considered if there is concern about an increase in inflation because they are inflation-adjusted. The earnings rate cannot go below zero and that the value of I bonds cannot drop below their redemption value. Additional Questions for Class Discussion The following are questions and answers may be used for class discussion, for additional homework, or exam questions. 4-1. What is cash management, and what are its major functions? Cash management is an activity that involves the day-to-day administration of cash and near-cash liquid resources by an individual or family. The major functions of cash management are (1) making sure that adequate funds are available to meet both planned and unplanned expenditures and (2) establishing an ongoing savings program that cushions against financial emergencies and accumulates funds to meet financial goals. 4-2. Give two reasons for holding liquid assets. Identify and briefly describe the popular types of liquid assets. Liquid assets are held for two broad reasons: (1) to meet known, near-term spending needs and (2) to meet unplanned future needs. See Exhibit 4.1 for a list of liquid assets and a representative rate of return for each. 4-3. Explain the effects that historically low interest rates have on borrowers, lenders, savers, and retirees. The current low interest rates encourages businesses to rely on debt which increases the risk of going into business. Also, the low rates discourages saving which has negative impact for the long run financial health of the financial plan. Inflation adjusted real interest rate has been negative, which means that savers are not keeping up with inflation and will either have to tap into their principal or cut their spending. This is bad for retirees and the overall economy. The benefits of lower interest rates include the reduced costs of financing the massive federal budget deficit, which is a significant savings given that interest on the federal debt was $431 billion in 2014. And lower rates have helped support the “too big to fail” banks. Indeed, the Fed’s low interest rate policy has allowed banks to pay less than 1 percent interest on savings. But the costs are equally impressive. Low interest rates reduce income to retirees and to pension funds. Some retirees will have to dip into their principal, which could put more stress on welfare programs for the elderly and may prompt the government to increase its financial support of underfunded pension funds. 4-4. Briefly describe the basic operations of—and the products and services offered by—each of the following financial institutions: (a) commercial bank, (b) savings and loan association, (c) savings bank, (d) credit union, (e) stock brokerage firm, and (f) mutual fund. Exhibit 4.2 gives a brief description of services offered by commercial banks, savings and loan associations, savings banks, credit union. From Exhibit 4.2: Commercial bank Offers checking and savings accounts and a full range of financial products and services; the only institution that can offer non-interest-paying checking accounts (demand deposits). The most popular of the depository financial institutions. Most are traditional brick-and-mortar banks, but Internet banks—online commercial banks—are growing in popularity because of their convenience, lower service fees, and higher interest paid on account balances. Savings and loan association (S&L) Channels the savings of depositors primarily into mortgage loans for purchasing and improving homes. Also offers many of the same checking, saving, and lending products as commercial banks. Often pays slightly higher interest on savings than do commercial banks. Savings bank Similar to S&Ls, but located primarily in the New England states. Most are mutual associations—their depositors are their owners and thus receive a portion of the profits in the form of interest on their savings. Credit union A nonprofit, member-owned financial cooperative that provides a full range of financial products and services to its members, who must belong to a common occupation, religious or fraternal order, or residential area. Generally small institutions when compared with commercial banks and S&Ls. Offer interest-paying checking accounts—called share draft accounts—and a variety of saving and lending programs. Because they are run to benefit their members, they pay higher interest on savings and charge lower rates on loans than do other depository financial institutions. From the text: Stock brokerage firms offer several cash management options, including money market mutual funds that invest in short-term securities and earn a higher rate of interest than bank accounts, special “wrap” accounts, and credit cards. Mutual funds, discussed in detail in Chapter 13, provide yet another alternative to bank savings accounts. Like stockbrokers, mutual fund companies offer money market mutual funds. 4-5. What role does the FDIC play in insuring financial institutions? What other federal insurance program exists? Explain. The FDIC provides deposit insurance on accounts up to $250,000 for commercial banks and thrift institutions. The FDIC insurance requires a deposit account at the financial institution. This type of insurance is not available on money market mutual funds, which are offered by investment companies, but it is offered by credit unions which are insured by the National Credit Union Administration (NCUA). The National Credit Union Share Insurance Fund (NCUSIF) is the federal fund used by the NCUA to insure accounts at credit unions for up to $250,000 per depositor. 4-6. Would it be possible for an individual to have, say, six or seven checking and savings accounts at the same bank and still be fully protected under federal deposit insurance? Explain. Describe how it would be possible for a married couple to obtain as much as $1,500,000 in federal deposit insurance coverage at a single bank. A married couple can obtain as much as $1,500,000 in coverage, apart from the coverage of CDs noted below, by setting up several accounts: • One in the name of each spouse ($500,000 in coverage) • A joint account in both names (good for $500,000, which is $250,000 per account owner) • Separate trust or self-directed retirement (IRA, Keogh, etc.) accounts in the name of each spouse (good for an additional $250,000 per spouse) 4-7. Distinguish between a checking account and a savings account. A checking account held at a financial institution is a demand deposit, meaning, that the bank must permit these funds to be withdrawn whenever the account holder demands. Savings deposits are referred to as time deposits because they are expected to remain on deposit for longer periods of time than demand deposits. 4-8. Define and discuss (a) demand deposits, (b) time deposits, (c) interest-paying checking accounts. a. Demand deposit refers to an account held at a financial institution from which funds can be withdrawn (in check or cash) upon demand by the account holder. As long as sufficient funds are in the account, the bank must immediately pay the amount indicated when presented with a valid check or when accessed with a debit card or when the account holder appears in person. This means that money in checking accounts is liquid and can be easily used to pay bills and make purchases. b. Time deposits are expected to remain untapped for a longer period of time than demand deposits. While financial institutions generally retain the right to require a savings account holder to wait a certain number of days before receiving payment on a withdrawal, most are willing to pay withdrawals immediately. Typically, a savings account pays interest at a fixed rate, and money is held in this type of account in order to accumulate funds for known future expenditures or to meet unexpected financial needs. c. Interest-paying checking accounts are distinguished from regular checking accounts which are not required to pay interest. As a result of the changes in the laws governing financial institutions in the late 1970s and early 1980s, depositors now have the opportunity to choose among a wide variety of accounts to meet their checking and cash balance needs. Each of these accounts has its own specific characteristics. Interest-paying checking accounts include money market mutual funds (MMMFs) which are offered through investment (mutual fund) companies and are not FDIC insured, money market deposit accounts (MMDAs), and NOW accounts. MMDAs and NOW accounts are available at virtually every deposit-taking financial institution in the U.S. and are federally insured (provided the institution offers FDIC or NCUA insurance, and virtually all do). 4-9. Briefly describe the key characteristics of each of the following forms of interest paying checking accounts: (a) NOW account, (b) MMDA, and (c) MMMF. a. NOW accounts (or negotiable order of withdrawal accounts) have been popular since the removal, beginning in 1986, of all interest rate restrictions. The account itself pays interest and offers unlimited check writing privileges so that investors can view the account as both a savings account and a convenience checking account. While no legal minimum account balance exists, many institutions impose at least a $500 minimum. Many banks also charge fees on the use of these accounts, such that in some cases the fees may negate the amount of interest earned. b. Money market deposit accounts (MMDAs) are vehicles offered by banks, S&Ls, and other depository institutions to compete with money market mutual funds. Unlike MMMFs, MMDAs are federally insured. Depositors have access to their funds through check-writing privileges or through automated teller machines. However, most require minimum balances, and there is usually a limit on the total number of transfers permitted during a month, with additional transfers subject to a penalty charge. This limits the flexibility of the accounts, but most people look upon them as savings accounts rather than as convenience accounts, so this is normally not a serious obstacle. c. Money market mutual funds (MMMFs) are offered by investment companies and pool the funds of many small investors to purchase high-yielding, short-term marketable securities offered by the U. S. Treasury, major corporations, large commercial banks, and various government organizations. The main advantage of these types of accounts to the small investor is that you can indirectly own these types of marketable securities by making fairly small minimum deposits, often 500; owning such securities directly may require a higher minimum investment. The interest rate earned on a MMMF depends on the returns earned on its investments, which fluctuate with overall credit conditions. Investors typically have instant access to their funds through check-writing privileges, although the checks often must be written for at least a stipulated minimum amount. In the banking system, checks written on MMMFs are treated just like those written on any other demand deposit account, and although they are considered very safe, these funds are not federally insured. 4-10. Describe the features of an AMA, its advantages, and its disadvantages. The AMA [Asset Management Account] is a comprehensive deposit account that combines checking, investing, and borrowing activities and is offered primarily by brokerage houses and mutual funds. AMAs appeal to investors because they can consolidate most of their financial transactions at one institution and on one account statement. A typical AMA account includes an MMDA [Money Market Demand Account] with unlimited free checking, a Visa or MasterCard debit card, use of ATMs, and brokerage and loan accounts. Their major advantage is that they “sweep” balances in excess of a minimum amount into a money market fund which pays a higher interest than banks. Disadvantages include a lack of “branch locations” compared to commercial banks. Also, the ATM transactions are handled through affiliates and are more costly than banks. 4-11. Briefly describe (a) debit cards, (b) banking at ATMs, (c) preauthorized deposits and payments, (d) bank-by-phone accounts, and (e) online banking and bill-paying services. These are alternative forms of Electronic Funds Transfers systems. They provide convenience to the customers and cost savings to the banks. Security is always an issue. The customer must safeguard their passwords [PIN] and the bank must have security procedures for its system. With sophisticated hackers, the risk of electronic funds transfers is a concern. a. Debit cards are specially coded plastic cards that permit cash withdrawals at ATM machines or allow a transfer of funds from your checking account to the recipient's account. ATM cards are one form of debit card, and Visa and MasterCard also issue debit cards. They provide a convenient form of payment and are accepted at many retail and service establishments. But remember to record all debit card purchases in your checkbook ledger to avoid overdrawing your account. For some transactions, the bank will withhold an additional amount to the charge to provide for anticipated changes in the amount of the final transactions, e.g. tips at a restaurant. Such additional charges may cause overdrafts. b. An automated teller machine (ATM) is a remote computer terminal at which bank customers can make deposits, withdrawals, and other types of basic transactions. The ATM can operate 24 hours a day, seven days a week. Banks and other depository institutions locate them in places convenient to shopping, offices, and travel facilities. Most banks do not charge their customers for this service. If not a customer, they do charge. c. Another form of EFTS service is the pre-authorized deposit, an automatic deposit made directly into your checking account on a regular basis. Some examples are paychecks, social security payments, and pension checks. Similarly, preauthorized payments allow a customer to authorize the bank to automatically make monthly payments for mortgages and other loans, utilities, or mutual fund purchases. d. Bank-by-phone accounts allow customers to make many types of banking transactions using their telephones. They can either talk to a customer service representative or use a touch-tone phone to verify balances, find out whether a check has cleared, transfer funds, and, at some banks, pay bills. e. Online banking and bill payment services enable one to handle nearly all account transactions from a personal computer at any time of the day or night and on any day of the week. Basically, with an online banking setup the customer instructs the bank to pay various bills by electronically transferring funds to designated payees. One can also call up a current "statement" on the computer screen at any time to check on the status of transactions, including checks written the traditional way. However, these systems do not permit one to make deposits or cash withdrawals through the home computer. This can only be accomplished by going to the bank or an ATM. The cost of electronic home banking systems is small once the person has the computer. The cost of a full-service teller transaction is about $1, an ATM transaction is less than 30 cents, and an Internet transaction is less than 1 cent. 4-12. What are your legal rights and responsibilities when using EFTSs? You are responsible for your actions. To prevent unauthorized charges you must notify the issuer promptly. You must notify the bank immediately about the theft, loss, or unauthorized use of your EFTS card. Notification within 2 business days after you discover the card missing limits your loss to $50. After 2 business days, you may lose up to $500 (but never more than the amount that was withdrawn by the thief). If you don’t report the loss within 60 days after your periodic statement was mailed, you can lose all the money in your account. 4-13. What are the key factors to consider when opening a checking account? Discuss the advantages and disadvantages of individual versus joint accounts. Factors that typically influence the choice of where to maintain a checking account are convenience, services, and cost. Many people choose a bank based solely on convenience factors: business hours, location, number of drive-thru windows, and number and location of branch offices and ATMs. The availability of additional services may also be important. Many banks also offer online and telephone banking and bill-paying services, safe-deposit box rental, provision for direct deposits and withdrawals, and mutual-fund sales. One advantage of the joint account over two individual accounts is lower service charges. In addition, the account has rights of survivorship: for a married couple, this means that if one spouse dies, the surviving spouse, after fulfilling a specified legal requirement, can draw checks on the account. 4-14. Is it possible to bounce a check because of insufficient funds when the checkbook ledger shows a balance available to cover it? Explain what happens when a check bounces. Can you obtain protection against overdrafts? It is possible to bounce a check due to insufficient funds when the checkbook ledger shows a balance available to cover it if certain deposits added to the checkbook ledger have not yet been credited to the account by the bank. This situation could also arise when certain service fees are deducted from the account by the bank, but the account holder has not yet been notified and therefore has not yet deducted them from his or her checkbook ledger. When a check bounces, the bank stamps the overdrawn check with the words “insufficient balance (or funds)” and returns it to the party to whom it was written. The account holder is notified of this action, and a penalty fee of $20 to $25or more is deducted from his or her checking account. In addition, the depositor of a “bad check” may be charged as much as $15 to $20 by its bank, which explains why merchants typically charge customers who give them bad checks $15 to $25or more and refuse to accept future checks from them. To prevent bounced checks, you can arrange for overdraft protection through an overdraft line of credit or automatic transfer program. Here the bank will go ahead and pay a check that overdraws the account, but be aware that bank charges and policies vary widely on the cost and terms of such protection. The bank may even extend such protection without prior arrangement, but in such a case it will notify the account holder of the overdraft and charge a penalty for the inconvenience. 4-15. Describe the procedure used to stop payment on a check. Why might you wish to initiate this process? Payment on a check is stopped by notifying the bank. Normally, the account holder fills out a form with the check number and date, amount, and the name of the payee. Some banks accept stop-payment orders over the telephone or online and may ask for a written follow-up. Banks charge a fee ranging from $20 to $35 to stop payment on a check. If checks or checkbook are lost or stolen, there’s no need to stop payment on them because the holder has no personal liability on that. Several reasons to issue a stop payment order include: A good or service paid for by check is found to be faulty. A check is issued as part of a contract that is not carried out. 4-16. What type of information is found in the monthly bank statement, and how is it used? Explain the basic steps involved in reconciling an account. Your monthly bank statement contains an itemized listing of all transactions (checks written, deposits made, electronic funds transfer transactions such as ATM withdrawals and deposits and automatic payments) within your checking account. It also includes notice of any service charges levied or interest earned in the account. Many banks also include canceled checks and deposit slips with the bank statement. The monthly bank statement can be used to verify the accuracy of the account records and to reconcile differences between the statement balance and the balance shown in the checkbook ledger. The monthly statement is also an important source of information needed for tax purposes. The basic steps in the account reconciliation process are: Upon receipt of the bank statement, arrange all canceled checks in descending numerical order based on their sequence numbers or issuance dates. Compare each check amount, from the check itself or the statement, with the corresponding entry in the checkbook ledger to make sure that no recording errors exist. Place a checkmark in the ledger alongside each entry compared. Also check off any other withdrawals, such as from ATMs or automatic payments, and make sure to add any checks written or deposits made which are shown on the bank statement but you forgot to record in your checkbook. List all checks and other deductions (ATM withdrawals, automatic payments) still outstanding (deducted in the checkbook but not returned with the statement.) Repeat the process for deposits. All automatic deposits and deposits made at ATMs should be included. Determine the total amount of deposits made but not shown on the bank statement (deposits in transit). Subtract the total amount of checks outstanding (from step 3) from the bank statement balance, and add the number of outstanding deposits (from step 4) to this balance. The resulting amount is the adjusted bank balance. Deduct the amount of any service charges levied by the bank and add any interest earned to the checkbook ledger balance. The resulting amount is the new checkbook balance. This amount should equal the adjusted bank balance (from step 5). If not, check all of the addition and subtraction in the checkbook ledger, because there probably is a math error. 4-17. Briefly describe each of these special types of checks: a. A cashier's check is drawn on the bank, rather than a personal or corporate account, so that the bank is actually paying the recipient. There is a service fee in addition to the face amount. b. Traveler's checks provide a safe, convenient way to carry money while traveling because they are insured against loss. They are purchased from financial institutions in certain denominations for the face value plus a fee. c. A certified check is a personal check guaranteed by the bank as to availability of funds. The bank charges minimal or no charge fee for this guarantee. 4-18. In general, how much of your annual income should you save in the form of liquid reserves? What portion of your investment portfolio should you keep in savings and other short-term investment vehicles? Explain. Although opinions differ as to how much you should keep as liquid reserves, the post-crisis consensus is that most families should have an amount equal to at least 6 to 9 months of after-tax income. Many financial planning experts recommend keeping a minimum of 10 percent to 25 percent of your investment portfolio in savings-type instruments in addition to the 6 to 9 months of liquid reserves noted earlier. Many savers prefer to keep their emergency funds in a regular savings or money market deposit account at an institution with federal deposit insurance. 4-19. Define and distinguish between the nominal (stated) rate of interest and the effective rate of interest. Explain why a savings and loan association that pays a nominal rate of 4.5 percent interest, compounded daily, actually pays an effective rate of 4.6 percent. The nominal rate of interest is the stated rate of interest, so in this instance the S&L’s nominal interest rate is 4.5%. The effective rate of interest is the interest rate actually earned over the period of time that the funds are on deposit. It is found by dividing the dollar amount of interest earned over the course of one year by the amount of money on deposit. We can determine the effective rate when the S&L has a stated rate of 4.5% by calculating how much interest is actually paid during the year. The easiest way is with a financial calculator because the S&L compounds daily in this example. We will arbitrarily choose to calculate the interest on a $1,000 account. (The percentage rate will be the same no matter what dollar amount we choose to begin with.) Set the calculator on End Mode and 1 Direct computation with Excel is $1.000 * ((1 + (.045/365))^365 = 1,046.025 which rounds to $1,046.03. During the year, this account earned $46.03 in interest, so we take the interest earned and divide it by the beginning principal to determine the effective interest rate. 4-20. What factors determine the amount of interest you will earn on a deposit account? Which combination provides the best return? The amount of interest earned depends on several factors, including frequency of compounding, how the bank calculates the balances on which interest is paid, and the interest rate itself. Look for daily or continuous compounding and a balance calculation using the "day of deposit to day of withdrawal" method. This is the most accurate balance determination and gives depositors the highest interest earnings for a given period. It is also considered the fairest procedure since depositors earn interest on all funds on deposit during the period. This method is sometimes called daily interest, but it should not be confused with the daily compounding of interest, which is an entirely different concept. 4-21. Briefly describe the basic features of each of the following savings vehicles: (a) CDs, (b) U.S. Treasury bills, (c) Series EE bonds, and (d) I savings bonds. a. Certificates of deposit (CDs) are savings instruments that require funds to remain on deposit for a specified period of time and can range from seven days to a year or more. Although it is possible to withdraw funds prior to maturity, an interest penalty usually makes withdrawal somewhat costly. While the bank or other depository institution can impose any penalty it wants, most result in a severely reduced rate of interest—typically a rate no greater than that paid on its most basic regular savings account. CDs are attractive for the highly competitive yields they offer, the ease with which they can be purchased, and the protection offered by federal deposit insurance. In addition to purchasing CDs directly from the issuer, "brokered CDs" can be purchased from stockbrokers. b. U.S. Treasury bills (T-bills) are obligations of the U.S. Treasury issued as part of the on-going process of funding the national debt. T-bills are sold on a discount basis now in minimum denominations as low as $1,000 and are issued with 3-month (13-week), 6-month (26-week), and one-year maturities. They carry the full faith and credit of the U.S. government and pay an attractive and safe yield that is free from state and local income taxes. They are almost as liquid as cash, because they can be sold at any time in a very active secondary market without any interest penalty. If they should be sold before maturity, however, one can lose money if interest rates have risen. In addition, broker's fees have to be paid in order to sell T-bills prior to maturity. c. Series EE bonds are the well-known savings bonds that have been around for decades. They are often purchased through payroll deduction plans or at banks or other depository institutions. Though issued by the U.S. Treasury, they are very different from U.S. Treasury bills. The fixed interest rate is set every six months in May and November, and change with prevailing Treasury security market yields. They increase in value every month, and the fixed interest rate is compounded semiannually. The interest is exempt from state and local taxes and, for federal tax purposes, it does not have to be reported until the bonds are cashed. In addition, when the bond proceeds are used to pay educational expenses, such as college, the tax on bond earnings may be partially or completely avoided if the taxpayer’s income falls below a certain level at the time of redemption (other restrictions apply). d. I Savings Bonds are similar to Series EE bonds in numerous ways. Both are issued by the U.S. Treasury and are accrual-type securities. I bonds are available in denominations between $25 and $10,000. Interest compounds semiannually for 30 years on both securities. Like Series EE bonds, I savings bonds’ interest remains exempt from state and local income taxes but does face state and local estate, inheritance, gift, and other excises taxes. Interest earnings are subject to federal income tax but may be excluded when used to finance education with some limitations. There are some significant differences between the two savings vehicles. Whereas Series EE bonds are sold at a discount, I bonds are sold at face value. I savings bonds differ from Series EE bonds in that their annual interest rate combines a fixed rate that remains the same for the life of the bond with a semi-annual inflation rate that changes with the Consumer Price Index for all Urban Consumers (CPI-U). In contrast, the rate on Series EE bonds is based on the 6-month averages of 5-year Treasury security market yields. Thus, the key difference between Series EE bonds and I bonds is that I bond returns are adjusted for inflation. Note in particular that the earnings rate cannot go below zero and that the value of I bonds cannot drop below their redemption value. Like Series EE bonds, I bonds can be bought on the Web or via phone. I bonds offer the opportunity to “inflation-protect” your savings somewhat. I bonds cannot be bought or sold in the secondary market; transactions are only with the U.S. Treasury Critical Thinking Cases The following are questions and solutions to “Critical Thinking Cases” for your use. 4.1 June Xu’s Savings and Banking Plans June Xu is a registered nurse who earns $3,250 per month after taxes. She has been reviewing her savings strategies and current banking arrangements to determine if she should make any changes. June has a regular checking account that charges her a flat fee per month, writes an average of 18 checks a month, and carries an average balance of $795 (although it has fallen below $750 during 3 months of the past year). Her only other account is a money market deposit account with a balance of $4,250. She tries to make regular monthly deposits of $50–$100 into her money market account but has done so only about every other month. Of the many checking accounts June’s bank offers, here are the three that best suit her needs. • Regular checking, per-item plan: Service charge of $3 per month plus 35 cents per check. • Regular checking, flat-fee plan (the one June currently has): Monthly fee of $7 regardless of how many checks written. With either of these regular checking accounts, she can avoid any charges by keeping a minimum daily balance of $750. • Interest checking: Monthly service charge of $7; interest of 3 percent, compounded daily (refer to Exhibit 4.8). With a minimum balance of $1,500, the monthly charge is waived. June’s bank also offers CDs for a minimum deposit of $500; the current annual interest rates are 3.5 percent for 6 months, 3.75 percent for 1 year, and 4 percent for 2 years. Critical Thinking Questions 1. Calculate the annual cost of each of the three accounts, assuming that June’s banking habits remain the same. Which plan would you recommend and why? a. Regular checking, per-item plan: Service charge of $3 per month plus 35 cents per check. Monthly charge $3 * 3 = $9 + Per check charge $0.35 * 18 * 3 = $18.90 Total annual charge of $27,90 b. Regular checking, flat-fee plan (the one June currently has): Monthly fee of $7 regardless of how many checks written. Annual cost = $7 * 3 = $21 c. Interest checking: Monthly service charge of $7; interest of 3 percent, compounded daily. With a minimum balance of $1,500, the monthly charge is waived. Since June’s balance is always under $1,500, she will have monthly charges each month. Annual monthly service charge $7 * 12 = $84; Less interest earned $795 * .0305 = $24.25 Net annual cost = $59.75. From Exhibit 4.8, interest of 3 percent compounded daily equals an effective rate of 3.05%. Of the three, her current flat fee plan is most cost effective. 2. Should June consider opening the interest checking account and increasing her minimum balance to at least $1,500 to avoid service charges? Explain your answer. In order to maintain $1,500 minimum balance, June would have to move $705 from her money market account to the checking account. The rate on the money market account is most likely at least the same as the 3.05% June will earned on the checking account. Thus, the interest gained is equaled to the interest lost. But she will be earning 3.05% on her current average balance of $795 for an additional $24.25 per year. Also, she will not have to pay the service charge under her current plan of $21 per year. So June would save a total of $45.25 per year by electing the interest checking account. The interest checking account will be the better of the three if she is willing to move money from here Money Market account to the checking account. 3. What other advice would you give June about her checking account and savings strategy? June should start automatically transfer $100 per month to her money market account. The automatic transfer feature will assure that the money is transferred each month without June having to take action. Once the balance is $19,500 and $29,250, she can consider moving some of the money market to a higher paying liquid asset such as a CD. She needs to keep the monthly savings of $100 in place and review her budget to see if she can increase that amount. 4.2 Reconciling the Campbell’s Checking Account Caleb and Eva Campbell are college students who opened their first joint checking account at the American Bank on September 14. They’ve just received their first bank statement for the period ending October 5. The statement and checkbook ledger are shown in the table on the next page. Critical Thinking Questions 1. From the following information, prepare a bank reconciliation for the Campbell’s as of October 5, using a form like the one in Worksheet 4.1. After a review of their check ledger the following checks are still outstanding: Number 102 for $28.40; Number 104 for $16.75; and 108 for $17.25 Also, a deposit made on October 5 has not cleared the bank. From the bank statement: The balance per bank is $95.39; a service charge of $3.00 was listed; and interest paid for the period was $9.25 2. Given your answer to Question 1, what, if any, adjustments will the Campbell’s need to make in their checkbook ledger? Comment on the procedures used to reconcile their checking account and their findings. They do not have the $3 bank charges or the additional interest deposit of $9.25 recorded. Since this was the first month of the account, the reconciliation was simple. Bank charges and interest earned frequently are unknown until the statement comes, so they are always an adjustment item. In total, the checking account was well maintained. The value of a monthly reconciliation cannot be overstated. It is a standard control feature on checking accounts and should always be done. 3. If the Campbell’s earned interest on their idle balances because the account is a money market deposit account, what impact would this have on the reconciliation process? Explain. Perhaps the bank charges could be avoided by using a money market account. Also, there would be additional interest to add to their checkbook record each month. Otherwise the reconciliation would be the same. Certainly, the process would be the same with a money market account. Key Concepts Managing savings and liquid assets requires an understanding of the numerous opportunities available in the financial marketplace as a result of deregulation. Today, many new providers offer various types of savings accounts and vehicles. It is also necessary for those using these services to understand procedures relating to interest calculations, differences in account features, and procedures for opening, utilizing, and managing accounts—especially checking accounts. The following terms represent the key concepts/terms stressed in this chapter:
account reconciliation Verifying the accuracy of your checking account balance in relation to the bank’s records as reflected in the bank statement, which is an itemized listing of all transactions in the checking account.
automated teller machine (ATM) A remote computer terminal that customers of depository institutions can use to make basic transactions 24 hours a day, 7 days a week.
asset management account (AMA) A comprehensive deposit account, offered primarily by brokerage houses and mutual funds.
cash management The routine, day-to-day administration of cash and near-cash resources, also known as liquid assets, by an individual or family.
cashier’s check A check payable to a third part that is drawn by a bank on itself in exchange for the amount specified plus, in most cases, a service fee of $5 to $10.
certificate of deposit (CD) A type of savings instrument issued by certain financial institutions in exchange for a deposit; typically requires a minimum deposit and has a maturity ranging from 7 days to as long as 7 or more years.
certified check A personal check that is guaranteed (for a fee of $10 to $15 or more) by the bank on which it is drawn.
checkbook ledger A booklet, provided with a supply of checks, used to maintain accurate records of all checking account transactions.
compound interest When interest earned in each subsequent period is determined by applying the nominal (stated) rate of interest to the sum of the initial deposit and the interest earned in each prior period.
debit cards Specially coded plastic cards used to transfer funds from a customer’s bank account to the recipient’s account to pay for goods or services.
demand deposit An account held at a financial institution from which funds can be withdrawn on demand by the account holder; same as a checking account.
deposit insurance A type of insurance that protects funds on deposit against failure of the institution; can be insured by the FDIC and the NCUA.
effective rate of interest The annual rate of return that is actually earned (or charged) during the period the funds are held (or borrowed).
electronic funds transfer systems (EFTSs) Systems using the latest telecommunications and computer technology to electronically transfer funds into and out of customers’ accounts.
I Savings bond A savings bond, issued at face value by the U.S. Treasury, whose partially fixed rate provides some inflation protection.
Internet bank An online commercial bank.
money market deposit account (MMDA) A federally insured savings account, offered by banks and other depository institutions that competes with money market mutual funds.
money market mutual fund (MMMF) A mutual fund that pools the funds of many small investors and purchases high-return, short-term marketable securities.
negotiable order of withdrawal (NOW) account A checking account on which the financial institution pays interest; NOWs have no legal minimum balance.
nominal (stated) rate of interest The promised rate of interest paid on a savings deposit or charged on a loan.
overdraft The result of writing a check for an amount greater than the current account balance.
overdraft protection An arrangement between the account holder and the depository institution wherein the institution automatically pays a check that overdraws the account.
Series EE bond A savings bond issued in various denominations by the U.S. Treasury.
share draft account An account offered by credit unions that is similar to interest-paying checking accounts offered by other financial institutions
simple interest Interest that is paid only on the initial amount of the deposit.
stop payment An order made by an account holder instructing the depository institution to refuse payment on an already issued check.
time deposit A savings deposit at a financial institution; remains on deposit for a longer time than a demand deposit.
U.S. Treasury bill (T-bill) A short-term (3- or 6-month maturity) debt instrument issued at a discount by the U.S. Treasury in the ongoing process of funding the national debt.
traveler’s check A check sold (for a fee of 1 to 2 percent) by many large financial institutions, typically in denominations ranging from $20 to $100, that can be used for making purchases and exchanged for local currencies in most parts of the world.
Chapter Outline I. The Role of Cash Management in Personal Financial Planning A. The Problem with Low Interest Rates [See Exhibit 4.1 for sample rates] B. Shop for the Best Short-Term Interest Rates II. Today's Financial Services Marketplace A. Types of Financial Institutions 1. Depository Financial Institutions [Exhibit 4.2] 2. Non depository Financial Institutions B. How Safe Is Your Money? 1. Deposit Insurance [See Exhibit 4.3] III. A Full Menu of Cash Management Products A. Checking and Savings Accounts [Exhibit 4.4] 1. Checking Accounts 2. Savings Accounts 3. Interest-Paying Checking Accounts a. NOW Accounts b. Money Market Deposit Accounts c. Money Market Mutual Funds 4. Asset Management Accounts B. Electronic Banking Services 1. Electronic Funds Transfer Systems a. Debit Cards and Automated Teller Machines b. Preauthorized Deposits and Payments c. Bank-by-Phone Accounts 2. Online and Mobile Banking and Bill Payment Services C. Regulation of EFTS Services D. Other Bank Services IV. Maintaining a Checking Account A. Opening and Using Your Checking Account 1. What to look for in a Bank Account 2. The Cost of a Checking Account 3. Individual or Joint Account? 4. General Checking Account Procedures 5. Overdrafts 6. Stopping Payment B. Monthly Statements 1. Account Reconciliation 2. Reconcile Your Checkbook: do it NOW [Worksheet 4.1] C. Special Types of Checks 1. Cashier’s Check 2. Traveler’s Check 3. Certified Check V. Establishing a Savings Program A. Starting Your Savings Program B. Earning Interest on Your Money 1. The Effects of Compounding See Exhibit 4.6 2. Compound Interest Generates Future Value C. A Variety of Ways to Save 1. Certificates of Deposit 2. U.S. Treasury Bills 3 . Series EE Bonds 4. I Savings Bonds VI. Planning Over a Lifetime Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609

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