Chapter 4 Managing Your Cash and Savings Chapter Outline Learning Goals I. The Role of Cash Management in Personal Financial Planning A. The Problem with Low Interest Rates *Concept Check* II. Today's Financial Services Marketplace A. Types of Financial Institutions 1. Depository Financial Institutions 2. Nondepository Financial Institutions B. How Safe Is Your Money? 1. Deposit Insurance *Concept Check* III. A Full Menu of Cash Management Products A. Checking and Savings Accounts 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 Banking and Bill Payment Services C. Regulation of EFTS Services D. Other Bank Services *Concept Check* IV. Maintaining a Checking Account A. Opening and Using Your Checking Account 1. The Cost of a Checking Account 2. Individual or Joint Account? 3. General Checking Account Procedures 4. Overdrafts 5. Stopping Payment B. Monthly Statements 1. Account Reconciliation C. Special Types of Checks 1. Cashier’s Check 2. Traveler’s Check 3. Certified Check *Concept Check* V. Establishing a Savings Program A. Starting Your Savings Program B. Earning Interest on Your Money 1. The Effects of Compounding 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 *Concept Check* Summary Financial Planning Exercises Applying Personal Finance Manage Your Cash! Critical Thinking Cases 4.1 Judith Bao's Savings and Banking Plans 4.2 Reconciling the Lamars’ Checking Account Money Online! 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. 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 covered in this chapter include: 1. The importance of cash management in personal financial planning. 2. A discussion of the financial marketplace and how financial deregulation has greatly increased the number of financial services and financial service providers. 3. The role of traditional financial institutions—"banks"—in providing individuals with the financial services they need. 4. Federal deposit insurance programs. 5. The growing menu of financial products available to the individual. 6. Other important money management services, especially electronic funds transfer services. 7. How to save by purchasing short-term securities. 8. Understanding checking account procedures and how to reconcile accounts. 9. Procedures involved in establishing a savings program and factors that determine how much interest you earn on deposits. 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 phrases represent the key concepts stressed in this chapter: 1. Traditional banks: commercial banks and thrift institutions 2. Deposit insurance 3. Checking and savings products 4. Interest-paying checking accounts 5. Electronic banking 6. Electronic funds transfer 7. Account balance determination 8. The variety of savings instruments 9. Checking account procedures 10. Checking account reconciliation 11. Special types of checks 12. Compound interest Answers to Concept Check Questions 4-1. 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. Liquid assets are held for two broad reasons: (1) to meet known, near-term spending needs and (2) to meet unplanned future needs. Per Exhibit 4, 1, the popular types of liquid assets include: Cash: pocket money—the coin and currency in one's possession. Checking Account: a substitute for cash offered by commercial banks and other financial institutions, such as savings and loans and credit unions. Savings Account: a standard savings account pays a relatively low rate of interest and does not permit withdrawal of funds by check. Money Market Deposit Account (MMDA): primarily a savings vehicle that pays market rates of interest, offers limited check-writing privileges, and requires a fairly large (typically $1,000 or more) minimum deposit. These are offered by banking institutions and are federally insured. Money Market Mutual Fund (MMMF): a savings vehicle that is actually a mutual fund and, like money market deposit accounts, offers check-writing privileges. These are offered by investment companies and are not federally insured. Certificate of Deposit (CD): a savings instrument in exchange of funds left on deposit in a financial institution for a stipulated period of time. A penalty is imposed for early withdrawal of the funds. Usually pays an attractive interest rate, which can vary depending on the size and maturity of the CD. CDs do not have any check-writing privileges. U.S. Treasury Bill (T-bill): short-term, highly marketable securities issued in various maturities of 52 weeks or less by the U.S. Treasury. Typically offer competitive short-term interest rates. U.S. Savings Bond (EE): a popular savings vehicle issued by the U.S. Treasury. They are sold in denominations as low as $25 and are purchased for half their face value. 4-3. Extremely low interest rates favor borrowers and dampen the incentives to save. Many argue that low interest rates have helped protect banks or lenders from absorbing the consequences of their actions and redistribute wealth away from prudent savers. 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. Lower interest rates encourage the substitution of debt for equity in capital structures and as a result increase financial risk. Lower rates discourage savings and the reduction of debt in the economy. Regarding savings for retirement, for every 1 percent decline in interest rates, pension fund liabilities increase $180 billion. 4-4. a. Commercial banks are the largest of the four traditional banking institutions. They provide a full array of financial services including checking accounts, a variety of savings vehicles, credit cards, several kinds of loans, trust services, and numerous other services like safe deposit boxes, traveler's checks, and check-cashing privileges. They are often referred to as full-service banks. b. Savings and loan associations (S&Ls) are financial institutions that channel people's savings deposits into mortgage loans for purchasing and improving homes. Since deregulation, S&Ls have expanded their product offerings so that today they offer many of the same checking, savings, and lending services as commercial banks. In fact, on the surface it is hard to distinguish them from commercial banks. One major difference is that S&Ls do not offer regular checking accounts (regular checking accounts do not pay interest). They instead provide NOW accounts and money market deposit accounts. Another major difference between commercial banks and S&Ls is that some S&Ls are formed as mutual associations in which the depositors actually own the institution and the returns they receive are technically called dividends, not interest. However, these dividends are treated as interest for all practical purposes. There are also stockholder owned S&Ls where the depositors receive interest on their deposits instead of dividends. c. Savings banks are a special type of savings institution, similar to S&Ls and found primarily in New England. They offer MMDAs and NOW accounts and pay interest on deposits at a rate comparable to S&Ls. Most savings banks are mutual associations (owned by their depositors); the interest they pay is called dividends. As with mutual S&Ls, dividends are paid out at a fixed rate and any surplus profits are retained in the savings bank to provide greater protection for depositors. d. Credit unions are a special type of mutual association that provides financial services to specific groups of people with a common tie, such as their occupation, religion or fraternal order. They are owned, and in some cases operated, by their members. After qualifying for membership, a person joins the credit union by making a minimum deposit, which must be left on deposit in order to remain a member and borrow from the association. Credit unions pay interest on savings. These dividends are treated as interest like the dividend payments of other mutual associations. Frequently, however, the depositor does not know the dividend rate prior to distribution, because many credit unions pay out all or most of their profits. Members not only receive a favorable return on their deposits, they may also be able to borrow at rates lower than those offered by banks and other financial institutions. e. Stock brokerage firms may offer a variety of services in addition to buying and selling securities on behalf of their customers. Most provide money market mutual funds and wrap accounts; some offer credit card services as well. f. Mutual funds, or investment companies, often provide in their offerings one or more money market funds. Typically, these money market funds yield a higher rate of return than banking institutions offer and also allow check-writing privileges. 4-5. The FDIC provides deposit insurance on accounts up to $250,000 for commercial banks and thrift institutions. 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. An individual could have six or seven checking and savings accounts at the same bank and still be fully protected under federal deposit insurance as long as the total balance in all the accounts does not exceed $250,000. A married couple could obtain $1,500,000 in deposit insurance coverage without going to several banks by setting up individual accounts in the name of each spouse ($500,000 total coverage), a joint account in both names ($250,000 per account owner, or $500,000 total), and separate trust or IRA accounts in the name of each spouse (an additional $250,000 coverage per spouse). Deposits maintained in different categories of legal ownership are separately insured. So, you can have more than $250,000 insurance coverage in a single institution by opening accounts in different depositor names. The most common categories of ownership are single (or individual) ownership, joint ownership, and testamentary accounts. Separate insurance is also available for funds held for retirement purposes, e.g., Individual Retirement Accounts, Keoghs, and pension or profit-sharing plans. Find out more at www.fdic.gov. 4-7. A checking account is a demand deposit whereby withdrawal of funds from this account must be permitted as long as there are sufficient funds in the account. Funds may be accessed by writing checks against the account, by using a debit card or by personally going to the institution. Checking accounts typically pay no or very low interest and are used for paying bills and making purchases. A savings account is a time deposit. Funds are expected to remain on deposit for a longer period of time than demand deposits and are used for accumulating money for future expenditures or for meeting unexpected financial needs. Usually, checks are not written against savings accounts, and the interest offered is higher than that offered on checking accounts. 4-8. 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. 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. Asset management accounts (AMAs) are comprehensive deposit accounts that combine checking, investing, and borrowing activities. They are offered primarily by brokerage houses and mutual funds. Their distinguishing feature is that they automatically "sweep" excess balances into relatively high-yielding short-term investments, such as a money market mutual fund. They are not for everyone, since their stipulated minimum balance requirements typically may be $5,000 or higher. While not FDIC insured, these deposits are protected by the Securities Investor Protection Corporation (SIPC) and the firm's private insurance. 4-11. 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. 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. 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. The federal Electronic Fund Transfer Act outlines the rights and responsibilities of EFTS users. While it does not allow you to stop payment in the case of defective or problem purchases, it does require that banks investigate billing errors upon notification in writing within 60 days from the date the error appears on the billing statement or ATM or similar terminal receipt. The bank must respond within ten days of such notification. Failure to notify the bank within 60 days ends the bank's obligation to investigate the problem. You must also notify the bank promptly if your EFTS card is lost, stolen, or you suspect unauthorized use. The amount you could lose depends on the speed with which you notify the bank; it is limited to $50 if you notify the bank within two days, up to $500 if you notify the bank after two days but within 60 days, and up to all the money in your account if you fail to inform the bank within 60 days. Some states and institutions offer greater protection than this for their customers. Another provision of the law prohibits banks from requiring you to use EFTS for loan payments, although they can offer the incentive of a lower rate. You must also have the right to choose the bank where you will receive salary or government benefit payments via EFTS. In addition to federal and state consumer legislation, you can protect yourself by safeguarding your personal identification number (PIN). 4-13. When opening a checking account, you'll want to consider convenience (location of branches and ATMs, hours), services offered, and fees and charges for both deposit accounts and other services. These must be reviewed in conjunction with your personal needs. Individual accounts may be easier for some couples to maintain, as each person is responsible for his or her own account. Joint accounts may result in lower service charges and also have rights of survivorship if one account holder dies (if specified when the account is opened). Each couple should determine which account arrangement works best given their money styles and level of account balances. For example, if one partner regularly forgets to record checks written on a joint account, the other partner is likely to become annoyed and may bounce checks unexpectedly. 4-14. 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. 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. 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: 1. Upon receipt of the bank statement, arrange all canceled checks in descending numerical order based on their sequence numbers or issuance dates. 2. 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. 3. List all checks and other deductions (ATM withdrawals, automatic payments) still outstanding (deducted in the checkbook but not returned with the statement.) 4. 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). 5. Subtract the total amount of checks outstanding (from step 3) from the bank statement balance, and add the amount of outstanding deposits (from step 4) to this balance. The resulting amount is the adjusted bank balance. 6. 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. 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. The amount of liquid reserves you have on hand will depend on your personal circumstances (for example, if you have a salary continuance plan at work) but should keep at least six months of after-tax income. From 10 to 25% of your investment portfolio should be in liquid assets. This provides additional funding for unexpected needs, planned near-term expenditures, and investment opportunities. The actual amount will fluctuate based on interest rate levels. 4-19. 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 Payment/Year. 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. 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. 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 high 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. Financial Planning Exercises 1. 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 isn’t. Talk to your parents about considering investments in higher-quality corporate bonds for the short term of the low interest rates. Returns for these bonds typically go up as interest rates go down and alternatively go down as interest rates go up. Conversely, more moderate strategies for your parents would be to invest in stocks that typically pay high dividends and/or buy preferred stock. Temper your advice to your parents by letting them know that stocks are generally riskier than bonds, so the higher risk is an important consideration. 2. Individual student answers will vary depending upon the needs of the student. Commercial banks offer checking and savings accounts and a full range of financial products and services. They can offer non-interest-paying checking accounts (demand deposits). They are the most popular of the depository financial institutions. Most are traditional brick-and-mortar banks, but some 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 loans (S&Ls) channel 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 banks are similar to S&Ls, but are located primarily in the New England states. Most are mutual associations, which means their depositors are their owners and thus receive a portion of the profits in the form of interest on their savings. Credit unions are nonprofit, member-owned financial cooperatives that provide 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, these are smaller 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. 3. If your ATM card was stolen and $950 was withdrawn from your checking account, you would be liable for: a. $50 if you notified the bank the next day; b. $500 if you notified the bank six days later; and c. $950 (or all the money in your account, whichever is greater) if you waited 65 days to notify the bank. Some states provide even greater protection for debit card users, as do various banking institutions. 4. Student 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 6. Problem 6—Worksheet 4.1 7. Use the formula FV = PV × (1 + i)n as the tables in the appendix do not have 4%. Using the financial calculator, set on END MODE and 1 P/YR: Since you initially deposit $6,000 and end up with $7,299.92 in five years, the amount of interest earned is the difference, or $1,299.92. 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: 8. Short-term investment vehicles include CDs, U.S. Treasury bills, Series EE bonds, and I Savings bonds. I Savings bonds should be considered if there is concern about an increase in inflation because they are inflation-protected. T-bills are almost as liquid as cash because they can be sold at any time. However, 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. 9. a. Since Carl and Elaine have annual after-tax income of $82,000, their monthly income is $6,833.33 (i.e., $82,000/12). Based on holding at least six month's after-tax income as liquid reserves, Carl and Elaine should hold at least $41,000 (i.e. 6 × $6,833.33). 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 Blankenships, this would amount to between $15,000 and $37,500 (i.e., .10 × $150,000 and .25 × $150,000). 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 $56,000 (i.e., $41,000 + $15,000) and $78,500 (i.e., $41,000 + $37,500). However, the longer their investment time frame the less short-term investments are needed in their investment portfolio, particularly with adequate liquid reserves as described in part a. Solutions to Critical Thinking Cases 4.1 Judith Bao’s Savings and Banking Plans 1. Annual net cost of the different checking account plans: Regular checking, per-item plan:— Based on Judith’s current banking habits, the flat fee plan is the least expensive. 2. If Judith maintains the $1,500 minimum balance in an interest checking account, she will earn $45.75 ($1,500 × .0305 = $45.75). She would also save $21 in annual costs as calculated above, so she would be $66.75 better off each year. However, she would have to come up with another $705 in addition to the $795 she currently averages in her account. This money would probably have to be pulled from her money market deposit account, which is probably earning about the same amount as the interest checking account. So Judith would really be about the same on the interest earned off the additional $705. However, she would be able to avoid the $21 annual costs as well as earn $24.25 on the $795 (see above), leaving her $45.25 better off per year. 3. Judith should start a regular savings plan using direct deposit so that she makes monthly deposits and builds up a reserve account to about 3 months of her pay, or $9,750. Reviewing her budget—or making one if she doesn't have one—will reveal ways to find greater savings. Once her reserve account is funded, she should invest any excess in higher yielding securities. She should also periodically compare the rates of CDs vs. her checking account and money market deposit account to figure out her best choices. However, CDs do not offer her the flexibility that the other types of accounts do. 4.2 Reconciling the Lamars’ Checking Account 1. The bank reconciliation using Worksheet 4.1 appears on the following page. 2. The Lamars need to make two adjustments in their checkbook ledger. • Add in the $9.25 deposit made on September 25. Apparently they failed to write in this deposit amount at the time the deposit was made. • Subtract the $3.00 bank service charge from their checkbook ledger balance to accurately reflect this charge made against their account by the bank. With these two adjustments, the Lamars’ checkbook ledger balance will be: This adjusted balance now agrees with the values shown on lines A and B of the checking account reconciliation worksheet. Since the Lamars just opened this account, balancing it was fairly simple—there were no checks from prior periods outstanding, and the beginning balance of the account was zero. The checking account reconciliation form streamlines this process. 3. With a NOW account, the Lamars could have reduced their effective bank charges by the amount of interest earned during the period, which would have been noted on the monthly NOW account statement and entered on line 6 of the checking account reconciliation form. The effect of the interest earnings would have been an increase in both bank and checkbook balances. Case 4.2, Question 1—Worksheet 4.1 Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
Download
Close
Close
