Banks want you to open accounts with them, and in return they reward you with some extra cash over time. This extra money is called interest, and certain types of accounts pay you more interest than others. The amount of interest changes often, though, and some accounts carry restrictions, so it isn’t easy to choose which type of account to open. Here are some things to think about when deciding.
The two key terms you should know
Although it's nice to earn as much extra money as possible, it's important to remember that no matter what kind of account you open, the amount you earn can change. Also, keep in mind that some accounts make it much harder for you to take your money out of the bank. There are two key terms banks use when describing accounts, their restrictions, and the extra money they give you:
Return is the amount of money your account will earn (aka interest). There's always the risk that this amount can vary, but it's a fairly minor risk for accounts that come directly from banks.
Liquidity is how easy it is to take your money out of the bank. Some accounts are less liquid and lock up your money for a longer period of time. In return, though, these accounts usually pay you more interest.
The most common account types
- Checking accounts are as liquid as it gets. You can access your funds just by using your debit card to shop, hitting an ATM, or writing a check. They're also insured by the government up to $250,000 ($500,000 for joint accounts), so they’re very secure and low-risk. Checking accounts pay little or no interest, but some banks offer higher initial interest rates for new customers.
- Savings accounts give up a little liquidity for more interest. Some of the ways to move your money, like remote withdrawals and transfers, are limited to six per month. At many banks, money market accounts offer interest rates similar to savings accounts. Account holders are limited to the same six withdrawals per month, but money market accounts usually come with check-writing privileges. Both of these accounts are also insured.
- A certificate of deposit (or CD) gives up even more liquidity for even more interest. A CD will typically lock up your money for a set period of months or years. Laddering your CDs is a popular way to take advantage of changing interest rates. For example, you might have a certain amount of money handy and decide to divide that amount into three parts. Then, you might buy three CDs that hold your money for different amounts of time. As time goes on, you can either remove the cash from each CD or put the cash back into another CD. This provides a steady income and lets you benefit from the best interest rates as each CD grows. CDs issued by banks are insured.
- Bonds can take many forms, but all of them are essentially IOUs. When you buy a bond, you lend your money to a government agency or corporation for a set amount of time, and in return that agency or organization promises to pay you interest. Bonds can either pay monthly or quarterly interest for the life of the bond, or pay all of the interest at the end of the term. Most bonds are fairly liquid and can be sold within a day or two if needed. Keep in mind, though, that the value of bonds can be volatile, so selling can result in a loss. The agency or corporation can also default on a bond, making it worthless. Defaulting is when an agency or corporation fails to pay the interest they promised you. It's good to remember that bonds are generally not insured.
- Money market mutual funds--unlike bank money market funds, where the interest rate is set by the bank, money market mutual funds have fluctuating interest rates. Money market funds are very liquid, so you can withdraw some or all of your money at any time. They are not insured but are considered low-risk in most cases.
Knowing which restrictions to take on can be confusing, especially since the amount of interest you'll get for taking on those restrictions can change. With the right guidance, though, we know you'll find the right balance.
