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10 Essential Banking Definitions You Need to Know

5 min read

top 10 essential banking definitions you need to know

Written By

Brandi Marcene

Are you someone who feels lost in the world of banking jargon? Do terms like "APR," "liquidity," or "collateral" leave you scratching your head? Fear not! Understanding the language of banking is crucial for managing your finances effectively. In this beginner-friendly blog post, we'll break down 10 essential banking definitions that are fundamental for anyone looking to navigate the financial landscape with confidence.

Whether you're a young adult stepping into the world of personal finance or someone looking to brush up on the basics, this guide is here to demystify the terminology and empower you to make informed financial decisions. Let's dive in!

Annual Percentage Rate (APR)

APR is a critical term used in the world of banking and finance to represent the annualized cost of borrowing, expressed as a percentage. It encompasses not only the interest rate charged on a loan or credit card but also any additional fees or charges associated with the borrowing.

APR provides borrowers with a standardized way to compare the costs of different financial products, such as loans or credit cards, from various lenders. It factors in both the interest rate and any fees associated with the loan, giving borrowers a clearer picture of the total cost they can expect to pay over the course of a year.

For example, when comparing two loan offers, one with a lower interest rate but higher fees and another with a higher interest rate but lower fees, the APR allows borrowers to make an apples-to-apples comparison of the total cost of each loan.

Additionally, APR is required by law to be disclosed to consumers in loan agreements and credit card terms and conditions, ensuring transparency and helping borrowers make informed decisions about their borrowing options. Understanding APR is crucial for those looking to build your credit responsibly by managing borrowing costs effectively.

Compound Interest

Compound interest refers to the process of earning interest not only on the initial amount of money invested or borrowed (called the principal) but also on any interest that has accumulated over time. In other words, its interest is calculated on both the initial principal and the accumulated interest from previous periods.

Here's how it works:

  • Initial Investment or Loan: Let's say you invest $1,000 in a savings account or take out a loan for the same amount.

  • Interest Accrual: With compound interest, your balance grows not only based on the initial $1,000 but also on the interest earned in previous periods. So, if you're earning interest on an investment, the interest earned in the first period is added to the principal for the second period, and so on. Similarly, if you have a loan, the interest accrued in each period gets added to the outstanding balance.

  • Compounding Periods: The frequency at which the interest is compounded can vary. It could compound annually, semi-annually, quarterly, monthly, or even daily, depending on the terms of the investment or loan.

  • Accelerated Growth or Debt: Over time, compound interest can lead to accelerated growth of investments or, conversely, increasing debt burdens. The longer the period over which compound interest operates, and the higher the interest rate, the more significant its impact becomes.

APY(Annual Percentage Yield)

APY, or Annual Percentage Yield, is a standardized measure used to express the rate of return on an investment or savings account typically over one year. Unlike a simple interest rate, APY factors in the effect of compounding, which involves reinvesting the interest earned in previous periods to generate additional interest in subsequent periods.

When evaluating investments like certificates of deposit (CDs), stocks, or bonds, their rate of return is a key consideration. This rate of return represents the percentage of growth in the investment over a specified period, typically one year.

However, comparing rates of return across different investments can be challenging if they have varying compounding periods. For instance, one investment may compound interest daily, while another may compound quarterly or semi-annually.

Simply stating the percentage value of each investment's rate of return over one year can lead to inaccurate comparisons because it overlooks the impact of compounding interest. Understanding how often compounding occurs is crucial because more frequent compounding accelerates the growth of an investment.

This happens because with each compounding period, the interest earned is added to the principal balance, resulting in larger future interest payments calculated on the increased principal amount.

To manually calculate APY, you can use the following formula:

APY = (1 + r/n)^n – 1

Where:

- r represents the interest rate

- n denotes the number of compounding periods per year (for monthly compounding, n would be 12)

Routing Number

A routing number is a nine-digit numerical code used in the banking system to identify a specific financial institution within a country. In Canada, it's known as the Transit Number. This unique identifier is crucial for various financial transactions, including direct deposits, wire transfers, electronic payments, and setting up automatic bill payments.

Moreover, in scenarios where you hold a joint account with another individual, such as a spouse or family member, the routing number associated with that joint account remains the same. This consistency simplifies transactions involving joint accounts, streamlining the process for both parties involved.

When opening a bank account in Canada, you'll typically need to provide your bank's routing or transit number, along with your account number. This information ensures that funds are directed accurately to your account from other financial institutions or entities.

The routing number is divided into three parts:

  1. The first four digits represent the institution number, identifying the bank or credit union where the account is held.

  2. The next four digits represent the branch or location of the bank where the account was opened.

  3. The last digit is a checksum, used for error detection.

For example, let's say you're opening a bank account in Canada with ABC Bank, and the routing number for the bank is 1234-567. In this case:

- "1234" represents the institution number for ABC Bank.

- "567" represents the specific branch or location.

Knowing your bank's routing number is essential for initiating various financial transactions, ensuring the smooth and accurate transfer of funds between accounts, whether it's for receiving your paycheck via direct deposit or sending money to a friend or family member electronically.

GIC(Guaranteed Investment Certificate)

A Guaranteed Investment Certificate is a type of investment product offered by banks and credit unions in Canada. It's a fixed-term investment where you deposit a sum of money with a financial institution for a specified period, ranging from months to several years. In return, the institution guarantees to repay the principal amount plus interest at maturity.

If you’re wondering how does a GIC work, let’s find out!

  1. Deposit: When you invest in a GIC, you deposit a specific amount of money with the financial institution, known as the principal.

  2. Term: You choose the term or duration of the GIC, which can vary depending on your investment goals and risk tolerance. Common terms range from 1 year to 5 years, although longer terms are also available.

  3. Interest Rate: The financial institution offers you an interest rate for the duration of the GIC term. This rate may be fixed or variable, depending on the type of GIC you select.

  4. Guarantee: One of the key features of a GIC is its guarantee of principal. Regardless of fluctuations in the financial markets, you are guaranteed to receive back your initial investment (the principal amount) at the end of the GIC term

  5. Interest Payment: Interest earned on the GIC is typically paid out at the end of the term or at regular intervals throughout the term, depending on the terms of the GIC agreement.

  6. Redemption: While GICs are intended to be held until maturity, some institutions may allow for early redemption under certain circumstances. However, early redemption may result in penalties or loss of interest.

The most common form of penalty for withdrawing a GIC early is the loss of interest. Since GICs offer a fixed rate of return for a set period, withdrawing funds before the maturity date means forfeiting the interest that would have been earned if the GIC had been held until maturity.

NCUA(National Credit Union Administration)

The NCUA is a federal agency in the United States responsible for regulating and supervising federal credit unions and insuring deposits in these institutions. Similar to the Federal Deposit Insurance Corporation (FDIC) for banks, the NCUA provides deposit insurance protection to depositors in credit unions. These institutions are regulated entities that insures customers bank deposits are safeguarded.

Here's a closer look at the role and functions of the NCUA:

  1. Regulation and Supervision: The NCUA oversees federal credit unions, ensuring they operate in a safe and sound manner and comply with applicable laws and regulations. This includes conducting examinations, assessments, and audits to monitor the financial condition and risk management practices of credit unions.

  2. Deposit Insurance: One of the primary functions of the NCUA is to provide deposit insurance coverage for members' accounts at federal credit unions. This insurance protects depositors' funds in the event of a credit union failure, up to the specified limits.

  3. Coverage Limit: Similar to the FDIC's coverage limit for banks, the NCUA insures each depositor's accounts at federal credit unions up to $250,000 per individual, per credit union, for each ownership category. Common ownership categories include single accounts, joint accounts, certain retirement accounts, and trust accounts.

  4. Financial Stability: By providing deposit insurance, the NCUA helps maintain stability and confidence in the credit union system. Depositors can have peace of mind knowing that their funds are protected up to the insurance limit, even if their credit union were to experience financial difficulties or fail.

TFSA(Tax-Free Savings Account)

A TFSA is a financial tool available to Canadian residents that allows them to save and invest money in a tax-efficient manner. Unlike traditional savings or high-interest savings accounts, contributions made to a TFSA are not tax-deductible, but any income earned within the account, including interest, dividends, or capital gains, is tax-free.

Here's how a high-interest tax-free savings account works:

  1. Tax-Free Growth: Contributions made to a TFSA are made with after-tax dollars, meaning they are not tax-deductible. However, any investment income earned within the account, such as interest, dividends, or capital gains, is not subject to tax. This allows savings and investments to grow tax-free over time.

  2. Contribution Room: The Canadian government sets an annual contribution limit for TFSAs, which accumulates each year for individuals who are eligible to contribute. Unused contribution room can be carried forward indefinitely, allowing individuals to catch up on contributions in future years.

  3. Flexibility: TFSAs offer flexibility in terms of investment options. They can hold a variety of investment products, including cash, Guaranteed Investment Certificates (GICs), stocks, bonds, mutual funds, and exchange-traded funds (ETFs). This flexibility allows individuals to tailor their TFSA investments to their risk tolerance and investment objectives.

  4. Withdrawals: Unlike Registered Retirement Savings Plans (RRSPs), withdrawals from a TFSA are tax-free and can be made at any time for any purpose without penalty. This flexibility makes TFSAs an attractive option for both short-term and long-term savings goals.

  5. Overdraft Protection Coverage: Some financial institutions may offer TFSA products that include overdraft protection coverage. This means that if a TFSA is linked to a chequing account and there are insufficient funds in the chequing account to cover a transaction, funds can be automatically transferred from the TFSA to cover the shortfall, up to the available TFSA balance.

RRSP(Registered Retirement Savings Plan)

RRSP is a tax-advantaged investment account available to Canadian residents, designed to help individuals save for retirement. It offers tax benefits to encourage Canadians to save for their retirement years. Contributions made to an RRSP are tax-deductible, meaning they can be deducted from taxable income, reducing the amount of income tax owed in the year of contribution. Investment income earned within the RRSP, such as interest, dividends, and capital gains, grows tax-deferred until withdrawal, at which point it is taxed as income.

Here's how RRSPs work and how they compare to Tax-Free Savings Accounts (TFSAs):

  1. Tax Deductible Contributions: Contributions made to an RRSP are tax-deductible, meaning they reduce taxable income for the year of contribution. This provides immediate tax savings, as the individual's taxable income is effectively lowered, resulting in a reduction of income tax owed.

  2. Tax-Deferred Growth: Investment income earned within an RRSP, including interest, dividends, and capital gains, grows tax-deferred until withdrawal. This allows investments to compound more rapidly over time, as taxes on investment gains are deferred until funds are withdrawn from the RRSP.

  3. Retirement Savings: RRSPs are primarily intended for retirement savings, and there are restrictions on withdrawing funds before retirement age. Withdrawals from an RRSP are subject to income tax and may also incur withholding tax, depending on the amount withdrawn and the individual's tax residency status.

  4. TFSA vs. RRSP: TFSAs and RRSPs are both tax-advantaged accounts designed to help Canadians save for their financial goals. While contributions to a TFSA are not tax-deductible, withdrawals are tax-free, making TFSAs a flexible option for short-term savings goals or retirement savings for individuals in lower tax brackets. On the other hand, RRSPs offer immediate tax savings on contributions but are primarily intended for retirement savings, with restrictions on withdrawals before retirement age.

Credit Score

A credit score is a numerical representation of an individual's creditworthiness, based on their credit history and financial behavior. It serves as a crucial factor in determining a person's ability to qualify for loans, credit cards, mortgages, and other financial products. Credit scores are used by lenders to assess the risk of lending to a particular individual and to determine the terms and conditions of credit offered.

If you’re thinking, how is a credit score calculated, then here’s your answer:

  1. Calculation of Credit Score: Credit scores are typically calculated using information from credit reports provided by credit bureaus. The most widely used credit scoring models, such as FICO and VantageScore, consider several factors when determining a credit score:

  • Payment History: Timely payment of bills and loans is the most significant factor influencing credit scores.

  • Credit Utilization: The amount of credit used compared to the total available credit, known as credit utilization ratio, affects credit scores.

  • Length of Credit History: Longer credit histories generally result in higher credit scores.

  • Types of Credit: A diverse mix of credit types, such as credit cards, loans, and mortgages, can positively impact credit scores.

  • New Credit: Opening multiple new credit accounts within a short period may lower credit scores.

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  1. Monitoring Credit Score: It's essential to monitor your credit score regularly, which can be done through various methods, including free credit score services offered by credit bureaus and financial institutions. Monitoring allows individuals to stay informed about their credit health and detect any errors or fraudulent activity on their credit reports.

  2. Virtual Credit Card: Utilizing virtual credit cards for online transactions can help you protect your credit card information and prevent fraud.

  3. Credit Cards for People with Bad Credit: Individuals with poor or limited credit history may have difficulty qualifying for traditional credit cards. However, there are credit cards specifically designed for people with bad credit or no credit history.

  4. Boosting Credit: There are several strategies you can use to boost your credit scores, including:

  • Making timely payments on all bills and debts.

  • Keeping credit card balances low relative to credit limits.

  • Avoiding opening multiple new credit accounts within a short period.

  • It’s important to update your credit score every 30 to 90 days to stay informed about your current credit standing. By monitoring changes in your credit score, you can quickly identify any unexpected fluctuations or discrepancies that may indicate errors or fraudulent activity on your credit report.

PRO Deposit

"PRO Deposit" refers to a type of deposit account or financial product offered by financial institutions in Canada. Understanding Canada PRO deposit involves familiarizing oneself with the various types of deposit accounts available in Canada and their respective features, benefits, and requirements. This includes understanding the different types of deposit products offered by banks, credit unions, and other financial institutions, such as savings accounts, checking accounts, certificates of deposit (CDs), and money market accounts.

While the specific features of a "PRO Deposit" account may vary depending on the financial institution offering it, some common features or benefits may include:

  • Higher interest rates: PRO Deposit accounts may offer higher interest rates compared to standard deposit accounts, allowing account holders to earn more on their savings.

  • Enhanced services: PRO Deposit accounts may come with additional services or perks, such as dedicated customer support, priority service, or access to exclusive banking products or promotions.

  • Flexibility: PRO Deposit accounts may offer greater flexibility in terms of account management, withdrawal options, or transaction limits, providing account holders with more control over their finances.

Other Important Terms You Should Know

When it comes to managing your finances, having a solid understanding of banking terms is essential. Let's start by exploring the basics of a checking account. A checking account is a type of deposit account offered by banks and credit unions that allows you to deposit and withdraw funds as needed. It serves as a central hub for your day-to-day transactions, such as paying bills, making purchases, and withdrawing cash from ATMs.

When you need extra funds for a specific purpose, such as buying a car or covering unexpected expenses, you may consider borrowing money. This involves obtaining a loan from a financial institution, which you agree to repay over time with interest. The terms of the loan, including the interest rate and repayment schedule, will vary depending on the type of loan and your creditworthiness.

For those looking to earn higher interest rates on their savings, a money market account can be a better option. Similar to a savings account, a money market account is an interest-bearing account that allows you to deposit and withdraw funds. However, money market accounts typically offer higher interest rates and may require a higher minimum balance to open and maintain the account.

It's important to note that deposits in checking accounts, savings accounts, and money market accounts are typically insured by the Federal Deposit Insurance Corp or the National Credit Union Administration for credit unions. This means that if the bank or credit union were to fail, your deposits would be protected up to the specified limits.

When using a checking account or a credit card, you'll encounter the concept of a credit limit. A credit limit is the maximum amount of money you can borrow or charge on a credit card or line of credit. Exceeding your credit limit may result in fees or penalties, so it's important to manage your credit responsibly and stay within your limits.

Why Do You Need To Know These Banking Terms?

Understanding banking terms is important for several practical reasons:

Clear Communication: Knowing banking terms helps you communicate clearly with bankers, financial advisors, and lenders. It ensures that you understand what they're saying and can ask questions if something isn't clear.

Smart Decision-Making: When you understand terms like "interest rate," "APR," and "compound interest," you can make smarter decisions about loans, credit cards, and savings accounts. This means you can choose options that save you money or help you grow your savings faster.

Avoiding Mistakes: Understanding terms like "overdraft fees" and "predatory lending" can help you avoid costly mistakes. You'll know what to watch out for and can protect yourself from getting into financial trouble.

Financial Planning: With knowledge of terms like "budgeting" and "savings account," you can create a solid financial plan. This allows you to set goals, track your progress, and make adjustments as needed to achieve financial success.

Protecting Your Finances: Knowing terms related to security, like "identity theft," helps you protect yourself from scams and fraud. You'll know how to recognize suspicious activity and take steps to keep your money and personal information safe.

Wrapping Up

Understanding these 10 essential banking definitions is like having a key to unlock the door to financial literacy. These terms, from APR to credit score, form the foundation of your financial knowledge, allowing you to make informed decisions about your money.

And if you're feeling overwhelmed or unsure about your credit score, remember that you're not alone. With tools like KOHO, you can take proactive steps to build and improve your credit while managing your finances effectively. From international transfers with KOHO to everyday banking needs, we are here to help you achieve your financial goals, one step at a time.

Note: KOHO product information and/or features may have been updated since this blog post was published. Please refer to our KOHO Plans page for our most up to date account information!
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