Let's start with a very basic question: like most Millennials, is the entirety of your wealth held in a checking or savings account? If so, do you know the APY associated with your savings account? Is your annual percentage yield lower than inflation? Do you even know what I'm talking about...? If you answered "yes" to any of these questions, I'm sorry to say that your net worth is depreciating by $.019 per deposited dollar, per year.
While the outcome of the aforementioned question is simple to understand (you're losing money!), the explanation is not. For instance, I can tell you inflation is defined as an increase in general prices, which is linked to the money supply and controlled by the Federal Reserve's Janet Yellen. I can also tell you that APY simply describes the annual rate at which your savings account acquires compound interest. Unfortunately, these financial terms are dry and complex; they are rightly of no interest to most people. But if I outline how inflation historically averages 2% per year, and a generous APY at any commercial bank is currently .10%, you can deduce that .10% - 2% = -1.9%, or that you're losing $.019 per deposited dollar, per year.
In authoring this five-part series, I hope to encourage people of all ages and backgrounds to become curious about financial systems. Yes, it's important to know that you're losing money; however, it is my opinion that the economic reasoning behind such occurrences is far more valuable, especially in the long-term. By focusing on fundamentals, I hope to educate all readers about the extreme importance of personal finance, and break down the barriers that so often discourage individuals from pursuing financial knowledge.
Let's start simple, as the title so suggests. At a general level, most everyone has heard about bank accounts and credit cards. You've likely been told, in some form or fashion, that a savings account is beneficial; to a certain extent, this is true. But what many people fail to recognize is that not every financial account is created equal. For example, would you be able to define the actual purpose of a checking account? How about a savings account? Do you know the upper limit placed on federally-insured deposits? Have you ever heard of the FDIC?
Regardless of your present financial literacy, these questions have surprisingly rational answers. For instance, checking accounts are merely bank accounts from which you can deposit and withdraw money; they are insured by the Federal Deposit Insurance Corporation (FDIC) to the tune of $250,000. However, it would be unwise to place $250,000 into any bank account because of inflation (following the above example, a $250,000 investment would depreciate $4,750 in just one year). As such, checking accounts should maintain minimum balances, and be used for consistent payments via debit cards, checks, and transfers. Conversely, savings accounts are meant to hold larger balances for longer intervals. Whereas checking accounts are designed for active withdrawals, savings accounts house money for the long-term. In exchange for your deposits, banks pay you interest. However, interest rates are currently much lower than inflation, so don't deposit too much money into your savings account.
As for debit and credit cards, you should definitely know how they differ. For beginners, the terms are not interchangeable; they are not synonymous. Specifically, debit cards are payment instruments that act as a substitute for cash. They are most always linked to checking accounts and actually help limit expenditures. This is because you can never spend more money than is present in your checking account (although some banks allow you to overdraw funds). As such, debit cards are safe financial tools. The same cannot be said of credit cards. While debit cards are inherently less risky, credit cards allow you to borrow relatively vast sums of money; think of them as plastic cards that consistently offer you small loans. However, since these small loans are highly risky, credit card vendors and commercial banks implement exorbitant APR penalty rates (usually 27-30%).
For the sake of clarity, imagine my checking account only contains $1,500, but that I own a credit card with a $5,000 monthly spending limit. Since I don't presently have enough money to pay my $2,000 rent for August, I decide to use my credit card (thinking I'll make enough money by month's end to pay off the $500 difference). Unfortunately, unbeknownst to me, I get fired from my job a week later. As such, I don't have enough money at the end of August to pay my credit card bill. My penalty interest rate (or APR) on the missed payment is 27%. As such, since I can't immediately raise some capital, I end up owing the creditor an additional $135 (or $635 total) after just one year. However, if I successfully pay off my monthly outstanding balances, I begin to build a credit score, which serves as a barometer for how likely I am to successfully repay loans. This score is then used by financial institutions to determine my credit worthiness in the event I want to take out future loans (i.e. for a car or house).
As you can see, debit and credit cards are entirely separate financial devices. Each has individual risks and benefits. Nevertheless, regardless of their pitfalls, these instruments are highly important factors for the health of Western economies. In fact, 70% of our annual GDP is attributed to retail spending. That's nearly $12.5 trillion per year! As of may 2015, Americans held $901 billion in credit card debt. For reference, if U.S. credit card debt was a nation, it would have the 16th largest GDP in the world. Think about that, and all that you've hopefully learned from this post ... I'll be checking in again shortly.