Thursday, December 27, 2012

Common forms of payment (simplified)

What is a check (or cheque)?
A check is a 'withdrawal slip' from your bank account, made payable to another person.  Instead of going to the bank and withdrawing money to pay someone, you fill out a check and make it payable to someone, or a company.  

It's easy to use and write a check:
1. Write the payment date in the appropriate line
2. Write who to pay in the line that says "Pay:"_____, e.g. ABC Company, or Joe Smith
3. Write the amount in words in the line below, e.g. One hundred and 25/100 (dollars)
4. Write the amount in numbers in the box, e.g. $100.25
5. The account owner signs the check on the signature line (bottom right)
6. The "memo/for" line allows you to write a short description of the transaction, e.g. "utility bill"

Note: a check has a unique number, e.g. 2400 (above).  Other numbers include the bank/branch routing number (usually bottom left) and the owner's account number (bottom, to the right of the routing number).

Personal risk: Checks can be stolen, and used by other people (writing your checks to pay someone, or cashing your checks intended for someone else).

Business risk: People pay other people with checks that are sometimes drawn on accounts, without sufficient funds to meet the payment value.  This results in checks returned to the depositor (the person who banked the check) marked "Insufficient funds" (or similar).  The person who was paid will then need to contact the payer to retrieve funds in another way, often with great difficulty - that is why many retailers do not accept checks.
What is a credit card?

A convenient method of payment, accepted at most businesses, allowing the owner to purchase something without having to first draw cash from their bank account, before they go shopping.  However, the bank is lending you money, and most often at a very high interest rate (if you don't pay the outstanding balance in full when you receive your credit card statement).

Unlike the administration required to write a check (above), a credit card is simply presented and the retail store's banking machine will process the transaction automatically.  When you purchase amount has been approved, the bank has just extended you a loan.  Because your loan is unsecured (i.e. you have not provided the bank with any security to cover your loan), there is a cost to borrowing.

Personal risk: Your credit card can be used by someone else.  Although you will be able to convince the bank that you didn't make the purchase, protecting you in the event of fraud, this sometimes takes a lot of time and can be stressful.  Your credit card has to be safeguarded in the same manner as you would protect your checks or cash.

Business risk: Very little.  If someone has fraudulently used your credit card and the retailer did everything required of it to ensure 'good faith', they won't lose any money.  The business receives payment 'instantly', less a credit card fee deducted, as per their agreement with the credit card company (or bank).
What is a debit card?

A debit card creates an "electronic check", and it is used like a credit card.  Debit cards often look like credit cards.  Banks often issue debit cards with the marks "Visa" or "MasterCard" on the card, making it appear to look like a credit card, and offering the account holder the convenience of payment "accepted wherever major credit cards are accepted."  You make a payment in the same manner as with your credit card, except that you would be required to enter your unique identifier, called a PIN (Personal Identity Number).  

Unlike a credit card (which is a bank loan), a debit card transaction allows the retailer to receive payment immediately, and your bank account is reduced by the purchase amount.  If you pay a retailer $100, the retailer receives $100 immediately (less a small percentage fee, e.g. 2.5%), and your bank account balance is reduced by $100 at the same time.

Unless you have overdraft (loan) protection attached to your checking account, you cannot spend $100 via your debit card, if you do not have at least $100 in your bank account. Retailers therefore prefer debit cards to checks, because the risk of receiving a check drawn on an account with "insufficient funds", returned a few days later, is mitigated.

Personal and business risk: As above, for credit cards and checks.

What is cash?

Cash currency: a paper monetary system used in place of bartering in our modern economy.  Instead of paying e.g. for 1 sheep with 100 chickens (called bartering), I could buy 1 sheep with e.g. $100 in cash.  Less cash is used every day in developed countries, as more and more people use electronic banking methods (above).

Individuals exchange cash (or currency) hand-to-hand every day, especially for small purchases, like a cup of coffee.

Governments print cash.  That is why every country has a different currency (name, design, etc.).  Buyers and sellers in different countries also exchange currency, and this can be referred to as "foreign currency exchange."  Currencies are exchanged at a certain rate, also sometimes abbreviated as "FX rate" (foreign currency exchange rate).  The rate between different international currencies is determined by the market, or supply and demand.  For example, the more U.S. Dollars there are available, the lower the U.S. Dollar value would be vs. other international currencies.  More about this later.

Personal and business risk: Cash is easily exchanged anonymously, and the holder of the cash is deemed to be the owner of the cash.  Don't send someone cash in the mail!  If I buy something with a $10 note, no-one will ask me where I got it from, or whether it's mine.  However, if you walked into the bank to deposit a large amount of money in cash, they should ask you where/who/how you obtained the cash.

There are many ways to transfer cash from one person (or business) to another.  Other common methods include bank wires, bank checks, electronic funds transfers (or ACH in the U.S.).  These are more sophisticated payment methods, commonly used in business, and I will cover these in a later post.

In a next post, we'll explore basic budgeting - why and how?

Becoming financially literate is essential, and managing your money - cash, cards or debt - is a core skill every young person should have!