While many people may invest in real estate or in the stock market, everyone should have a fund that is kept out of either of these investments and kept in a savings type account.
Why? There are a number of reasons for this including (1) having a fund to access in the event of an emergency (2) having available funds for large expenses such as vacations, home improvements etc. and (3) saving for a major purchase such as a house or car.
Savings accounts may not provide a very high return, but they offer capital security as most of the products are FDIC insured. This insurance provides cover on account balances up to $100,000. Investing your cash in the stock market while saving for that house that you plan on buying in the next couple of years can be a very risky strategy. Sure, the market could go up in that time, meaning that you would reach your savings goal earlier. However, the market could just as easily fall, leaving you with a much longer time period before you can get that house.
There are a number of different savings products on the market that are suitable for short term savings. Indeed these short term savings can provide a halfway point if you are saving for an investment and need to gather up a minimum initial investment sum. These products should be compared by looking at the APY (Annual Percentage Yield). The APY is defined as the percentage to be disclosed on interest earning accounts that reflects the total interest to be earned, based on the institution’s compounding rate assuming the funds are in the account for a 365 day year. Let’s have a look at some of these short term products.
1. Checking Accounts
Yes, there are some checking accounts that pay interest (including those offered by brokerage houses). The advantage of a checking account is that you have immediate access to the funds, should they be needed.
This could also be a disadvantage as there is the temptation to dip into the funds for impulse purchases. Another disadvantage is that in order to earn interest (traditionally not a high rate either), a minimum balance must be maintained in the account.
2. Savings Account
The traditional savings account or savings passbook seems to have gone out of favor in recent years. The main reason for this is the low rates traditionally on offer for these accounts – along with the growth of the internet, where it is now much easier to find better returns at the click of a mouse.
These rates have fallen from over 2% 10 years ago to less than 0.5% today. However, these accounts generally have a very low or even no minimum balance requirement, which can make them a good place to get kids started on the habit of saving. Savings accounts also are insured under FDIC and are usually accessible on demand.
3. Money Market Accounts
Money market accounts are a step up from traditional savings accounts. There are different minimum required balance levels – the higher the minimum balance, the higher the interest rate. For example, a money market account with a $10,000 minimum balance would have an APY of 1.56%, whereas a money market account with a minimum balance of $25,000 would have an APR of 1.92%. Like savings accounts these are insured under FDIC and are accessible, though there may be a limit on the number of transactions allowed per month. There are also Jumbo Money Market accounts with minimum balances of $100,000 – however any excess of the $100,000 would not be covered by FDIC.
4. Certificates of Deposit
Commonly known as a CD, this is a fixed time deposit, offering different interest rates/APY’s depending on the term chosen. The shortest term CD is usually 1 month with the longest being 5 years. Currently 1 month CD’s are offering APY’s of 1%, with 5 year CD’s paying 3.91%. (10 years ago rates were over 5%). Returns will be higher than money market accounts but one of the main disadvantages is that the accountholder cannot withdraw money from their CD during the term without being subject to a penalty.
However, an investor can stagger their CD investments so that they have CD’s maturing on a regular basis. For example someone could have 5 one year CD’s maturing on 5 consecutive years instead of one 5 year CD maturing on the one date. In this way, the customer will have access to one of the funds every year without penalty and may be able to take advantage of any increase in rates when they go to re-invest in a new CD. Investors usually have the option of letting the interest roll over into the new CD or transferring the interest to another account.
5. Money Market Funds
These are different from money market accounts shown above as they are usually offered by mutual fund companies. The mutual fund companies invest in high quality short term securities offered by the government or government agencies. There are hundreds of these funds on the market place, each with their own minimum investment amounts. One advantage that these accounts offer is that it is possible to invest in a tax free fund.
Yields for taxable money market funds are currently running between 1.5% and 1.75%. Non-taxable funds are offering yields between 1.1% and 1.6%. It’s important to check the expense ratio (the fee charged by the mutual fund company to manage the fund) as that can have a significant impact on the returns. Also, these accounts are not insured by FDIC.
Aside from the above basic savings products, savers can also purchase government securities – bonds, treasury bills and treasury notes. Treasury bills have the shortest maturity dates – up to one year. Notes can mature anywhere from 2 to 10 years and bonds anywhere from 10 to 30 years. The minimum investment is $1,000. Notes and bonds pay interest every 6 months, and can be bought or sold on the open market. Treasury bills pay interest at maturity as it is built into the price of the bill. You purchase the bill for less than par value (say $950) and the bill is redeemed by the government at par value ($1,000) with the difference being the interest earned. Also, the interest earned on these is exempt from state and local taxes. Another federal bond is the I bond, which grow in value using inflation indexed earnings for terms of up to 30 years.
As well as Federal bonds, it is also possible to purchase State and Municipal bonds. Interest earned on these is usually exempt from federal taxes and may also be exempt from state and local taxes.
A good online short term savings option is ING Direct. They offer savings accounts and CD’s starting at competitive rates of 2.25% with no minimum balances required.
While the rates offered by these various savings products have been pretty miserable over the last few years, the recent increases in the Fed rate will drive up these rates also. While it is important to get the best possible return for your savings – search around for the best rates available and there are loads of sites on the internet offering this information – it is just as important to have access to the money in a hurry and have the capital secured. This savings account is not your entire savings, so don’t be looking to retire on it! It’s a small part of your overall portfolio, where access and capital security are as important as the interest earned.