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Recently, I had a lengthy conservation with a good friend of mine who had a ton of basic personal finance questions contained within. I thought it might be interesting to start an irregular “Your Money 101″ series to answer and explain some of his questions.

Most Dominicans see banks as being a place where you save your money or where you get open a checking account or where you can get loans, but a lot of people often don’t understand the big picture of how a bank functions. Let’s walk through it in simple (baby) steps so that you can understand why a bank exists.

First of all remember, a bank is a just like any other business: it strives to make as much money as possible. They make money by simply moving money around; keep that in mind as we go through the different services that a bank provides.

Most people the first service that they become familiar with in terms of a bank is a savings account. At first glance, a savings account is a situation in which you give a bank your money for a period of time, withdraw it whenever you like, and depending on how long leave it there it earns a small amount of money for you. What actually happens, though, is that a savings account is actually a loan, except this time you’re the lender. It’s no different than any other loan, except it’s really flexible: you can lend as much as you want to the bank and get that loan paid back whenever you’d like. Because of this flexibility, though, the interest you make on this loan is pretty low.

Likewise a checking account, at most banks, is no different than a savings account: you’re lending the bank your money, but with a checking account, they pay your interest with services (dealing with the checks you write, etc.) instead of interest.

The other major area that people think of when they consider a bank is loans: they lend money to people for buying a home, car, and other things.

So how does a bank make money? For starters, they take the money you loan them and earn a pretty strong return with it, then give you a part of that return in the form of interest. So, each dollar you put into your account with the bank makes them a little bit of money.

Let’s say, for example, that the bank has a savings account with a 1.5% rate of return, which is likely better than most banks in Dominica. They take the money from your account (and a lot of other savings accounts) and use all of that money to buy (for example) a treasury note, which is guaranteed returns about 5%.

Even better, let’s say that someone else comes into the bank and wants to borrow some money to start up a small business. The bank offers to lend them the money for the car at 7% return, so they take that money from the accounts at the bank and give it to the borrower. Then, the borrower pays back that money plus the interest, of which they pass on 1.5% to you, keeping 5.5% for them.

On top of that, banks today make a lot of money from fees. You get charged when you use the wrong ATM, when you overdraft a check, interest on your credit card(s) balance and so on. Each of these activities only costs the bank a few cents to handle, but it costs you a few dollars.

To summarize it, a bank works by paying people small amounts to lend their money, then lending that money onto others for larger amounts. They manage that whole process, and then keep the difference between the large amount (interest on loans) and small amount (interest from a savings account).

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The best place to invest your money is in yourself. I know a few people might not agree with me; but rate of return from investing in your own knowledge and skills will be much higher that anything you’ll see from real estate, stocks or other investments.

In some instances you can even measure the rate of return. For example you buy a book. Even add-in the cost of your average hourly rate multiplied by the time it took to read it. Many books will be lousy. But every now and then you’ll get one good idea that gives you a huge rate of return on your initial investment. Like 5x the cost in a matter of weeks. This is especially true with business on a whole. But often it isn’t an original idea but rather the continuous exposure to the same ideas presented in different ways that produces a steady return on investment over time. If investing in your own knowledge finally gives you the idea you need to quit drinking, you can measure the lifetime financial savings in the cost of alcohol. The question is – what is the increased level of health worth to you? What is the idea that allows you to meet and connect with your future worth?

A trick I learned is to invest 3% of your income on your own personal development. So if you earn $2500 per month, you’d invest just $75 per month on your own personal development. That mean very month you can invest in a self-help or personal development book; in Dominica these books are usually around $60-70 each. Or can use that $75 towards an afternoon class or a one day seminar on topic that you’re interested in or need development in. Most afternoon classes I’m familiar with are around $40-50 per month.

You don’t have to like me and spend that exact percentage every month. It’s fine to under-spend one month and overspend another. But aim for about 3% for the year on average. If that amount makes you uncomfortable, start with 1% the first month and build up gradually. Or just start with a fixed amount like $35 until you get the hang of it.

You can use this budget to invest in improving yourself any way you like. So that includes not just knowledge, but also equipment and services — anything that helps you grow and improve. For example, I used this budget towards going back to the gym; and that helped me remember how good I felt about myself when I was going to the gym on a regular basis. Once you beginning feel good about yourself, at feeling shines on other aspects of your life.

It’s a pretty easy habit to develop too. Just write on your calendar on the 1st of each month: “Invest 3% in myself.” Then when that date comes up, figure out how much money you made the previous month, and then decide how you’ll spend it. If you can, spend it right away — easy when you order online. Remember that this is an investment; the money you spend here will be repaid in the long run based on how you invest it.

Give it a try – Happy spending! 😆

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