The way to stay committed to your budget is to establish some external controls on yourself. Behavioral economists call these “nudges.” The best way to keep on track is to use your accounts at your financial institution to automatically stay on budget. I use the term “financial institution” purposely because there are certain truths you should know about financial institutions that are not easily evident:
- Commercial banks are not your friends.
- If you have your main checking account at a commercial bank, do not set up automatic bill paying there. You will be stuck! Switch to a credit union first.
- Credit unions are your friends.
- Most online stock trading companies such as Robinhood, TD Ameritrade, E*TRADE, etc. are not your friends.
- Non-profit mutual fund companies, such as Vanguard, and TIAA are your friends.
- Almost all stockbrokers and mutual fund companies currently allow you to trade stocks for free—that is, no stockbroker commissions on stock trades. If you want to trade stocks, I recommend Charles Schwab as the best broker to set up an account with.
With these facts in mind, we can now talk about how to use your financial institution to nudge you to stay on budget.
First, keep your checking and savings account at a credit union, not a commercial bank. Commercial banks such as Wells Fargo, Bank of America, JP Morgan/Chase, and Citicorp are in business to make a profit. They have to generate enough profit to pay dividends to their shareholders. The upshot of this is that they charge higher interest rates on their loans and pay lower interest rates on their deposits than credit unions.
Commercial banks, savings banks, and credit unions are called financial intermediaries. This means they take money in from depositors (to whom they pay interest) and lend it out to borrowers (who pay the bank interest). In order to cover their overhead (salaries, rent, advertising), financial intermediaries charge higher rates to their borrowers than they pay to their depositors. In addition, commercial banks also borrow money in the short-term money markets (also known as a Commercial Paper Market) at a low rate and lend it out to borrowers at a higher rate.
Since the commercial banks must pay interest to their depositors and interest to the Commercial Paper Market lenders, they are essentially borrowing all their money. Additionally, commercial banks must pay dividends to their owners and stockholders, adding to their expenditures. Thus, commercial banks must do the following:
- Pay interest to their depositors.
- Pay interest to their lenders in the short-term Commercial Paper market.
- Cover their overhead (salaries, buildings utilities, advertising, rent).
- Pay dividends to their owners and stockholders.
In general, commercial banks add a mark-up on the cost of funds between 3% and 4%. That is, if the bank is paying their depositors 1% on their savings accounts (and 1% on the Commercial Paper they borrow, since all short-term interest rates move in synchronization) this is their average cost of funds. On average, they will then charge 4% on their portfolio of loans.
The difference between what a financial institution charges its borrowers and what it pays its depositors (and lenders) is called the interest rate spread or the net interest margin. Below is the historical data on the interest rate spread at all U.S. Banks.
Figure 6.5. Federal Financial Institutions Examination Council (US) and Federal Reserve Bank of St. Louis, Net Interest Margin for all U.S. Banks (DISCONTINUED) [USNIM], retrieved from FRED, Federal Reserve Bank of St. Louis; September 30, 2021.
If you look closely, you will see two big spikes in the interest rate spreads, in 1994 and 2010. In these two years, the Federal Reserve Bank reduced the Federal Funds Rate dramatically as part of Monetary Policy to help the economy recover following recessions. Since all short-term interest rates (including deposit interest rates and Commercial Paper rates) move in lockstep with the Fed Funds Rate, this effectively reduces the cost of funds to banks, allowing them to make larger profits.
Credit unions, on the other hand, are all non-profit mutual institutions, entirely owned by their depositors. Therefore, these are the only expenses they have to cover:
- Pay interest to their depositors.
- Cover their overhead (salaries, buildings utilities, advertising, rent).
This is why credit unions can pay higher interest rates on saving accounts and charge lower interest rates on all their loans. They just need a slightly lower interest rate spread to cover their expenses. A recent average interest rate spread for credit unions was 3.15%.
Unfortunately, the basic business model for all financial intermediaries is inherently unstable. They are all subject to what is known as disintermediation. Disintermediation occurs when depositors demand their money back, but the bank does not have it. This can occur because financial intermediaries borrow short term and lend long term. Banks and credit unions borrow their money from depositors (or Commercial Paper Markets, in the case of commercial banks). and the depositors can demand its return at any time. However, the financial intermediaries have lent the depositors’ money out in loans that are paid back over time—auto loans, mortgages, credit card loans, etc.
When depositors demand more of their money back than the bank has on hand, this is known as a run on the bank. During the Great Depression (1929 to 1940) there were several runs on banks, and many banks went bankrupt, while numerous depositors lost their money. As a result, the Federal Deposit Insurance Corporation (FDIC) was created in 1933 by the federal government to insure depositors’ money. FDIC currently insures up to $250,000.00 per account in commercial banks against the bank’s insolvency. In 1970, in response to the explosive growth of credit union membership, the National Credit Union Share Insurance Fund (“NCUSIF”) was created by the federal government to fulfill a parallel function to the FDIC, but for credit unions. The NCUSIF also currently insures up to $250,000.00 per account in credit unions against the credit union’s insolvency.
Credit unions were initially set up to benefit employees at the same company, such as the Pentagon Federal Credit Union, the General Motors Employees Credit Union, or the AFL-CIO Credit Union. In the expansion of credit union membership after 1970, many of the credit unions relaxed their membership regulations and now anyone can join almost any credit union. Usually to join a credit union currently, you merely need to deposit a minimum of $5.00 in a savings account. Choose a credit union that has an office convenient to you (although that may not even be necessary, as you can do all your banking with credit unions electronically).