If you’re looking for a bit of steady income, or you’re saving for a relatively short-term goal, your interest…is earning interest. An interest-bearing asset is generally the best option for a monthly or quarterly check, or saving for a purchase such as a car, vacation, or the downpayment for a house.
With interest rates at historic lows, your options are more challenging than they’ve been in the past. All of the options involve trade-offs among three factors, and there is no “best” choice.
Here are the factors you should consider when choosing a savings vehicle.
The Three Trade-offs
Investment decisions generally involve how much you prioritize three aspects of every investment:
- Risk
- Return
- Liquidity
Risk comes in two forms: the possibility that you can lose some or all of your money, and the risk that the amount of interest you earn will fluctuate. As a general rule, risk and return tend to be on opposite ends of a see-saw; when one goes up, the other goes down. The safest investments are insured, so you won’t lose any money, and have a fixed rate of interest. Unfortunately that interest rate tends to be low.
Return is the interest you’ll earn. Pretty simple.
Liquidity is how easy or difficult it is to sell or cash in your investment. Some investments will lock up your money for a longer time in return for a higher interest rate. If you need to sell that investment before that time ends, you may take a financial hit or not be able to sell it at all.
No investment offers safety, a high return and liquidity. Again, you’ll have to decide on your priorities.
These are the trade-offs for different investments.
Checking Accounts
At one time many checking accounts carried no fees and paid interest. In today’s low-interest environment, that’s no longer the case. Many accounts require a minimum balance or another account (such as a savings account or CD) at the same institution just to avoid fees. Falling below the minimum balance can mean fees or financial penalties. Accounts that pay interest generally pay a minimum amount, though some have higher initial interest rates for new customers. A few online banks offer interest rates that are higher than many brick-and-mortar institutions.
On the upside, checking accounts are very liquid. You can access your funds just by using your debit card to shop, hitting an ATM, or going old school and writing a check. Some accounts limit the number of free checks or transactions per month, but most don’t.
Checking accounts are also very secure. Accounts at banks are insured by the Federal Deposit Insurance Corp (FDIC) up to $250,000 per person per bank. This includes both brick-and-mortar and online banks. Note that the $250,000 is for all accounts you may have at a given institution. Joint accounts are insured up to $250,000 per person. Credit union deposits are insured up to $250,000 by the National Credit Union Share Insurance Fund.
Some checking accounts come with perks, such as a bonus for new accounts. Again, those bonuses may require a minimum deposit or minimum balance. That bonus is the equivalent of earning extra interest, which is a nice perk.
Savings Accounts/Bank Money Market Accounts
Savings accounts give up a little liquidity for (generally) a higher interest rate. High-yield savings accounts are easy to find, and some of them include bonuses as well. Accounts at banks are insured just as checking accounts are.
The Federal Reserve Board Regulation D limits withdrawals and transfers from savings accounts to six per month. Exceeding that limit can trigger a fee, or even a bank’s decision to close your account or convert it to a checking account. Note that overdraft transfers to cover a check that exceeds the amount of money in your checking account is considered a transfer, too.
You can get around that limit by making certain types of transfers and withdrawals that the Federal Reserve says don’t count, such as physically visiting a bank and asking a teller to move your money. You can also get around the limit by asking the bank to mail you a check. The purpose of the regulation is to discourage people from using a savings account like a checking account
Beyond that, savings accounts are very liquid, and interest rates are set by the bank. The only minor downside is that if interest is credited at the end of a month or calendar quarter, withdrawing money in the middle of the month or quarter will mean giving up a few days or weeks worth of interest.
At many banks, money market accounts offer yields similar to savings accounts. Account holders are limited to the same six withdrawals per month as savings accounts, but money market accounts usually come with check-writing privileges. Note that money market mutual funds are different from bank money market accounts, as explained further below.
Certificates of Deposit (CD)
A certificate of deposit gives up even more liquidity for (generally) a higher interest rate. A CD will typically lock up your money for a set period of months or years. Withdrawing your money from a CD before the term is up will normally carry an interest-rate penalty, such as the loss of three months’ of interest. For that reason, don’t purchase CDs with money you may need in an emergency.
The highest yielding CDs are called jumbo CDs, and typically require a minimum of $100,000 to purchase.
CDs at a bank are FDIC-insured, and it’s worth shopping around to find the best rates. Laddering your CDs is a popular way to take advantage of varying interest rates.
Laddering simply means buying several CDs with varying terms. For example, if you have a certain amount to save, you might split it into three parts and buy equal denominations of one-year, two-year, and three-year CDs. As each one matures you can take the cash or roll it into another CD. This can provide a steady stream of income and gives you the opportunity to find the best prevailing rate as each CD matures.
Bonds
Bonds can take many forms, but all of them are essentially an IOU. 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. Those that pay regular interest are generally purchased at face value, so a $1,000 bond will cost $1,000. A bond that pays all of its interest at the end of its term will sell at a discount to its face value, and be worth its face value when it matures. The general types of bonds are:
Savings bonds: Available in denominations of $25-$10,000. Backed by the U.S. government, and interest is free from state and local taxes. Series EE bonds pay a fixed rate of interest; Series I bonds are indexed to inflation. Bonds are sold at face value and interest is deposited into the account you designate regularly. Bonds can be cashed in prior to maturity at most banks, but there are financial penalties for doing so.
Treasury Bills and Notes: These financial instruments aren’t called bonds, but they act just like them. They’re also backed by the full faith and credit of the U.S. government, similar to savings bonds, and are also exempt from state and local interest. Treasury Bills have maturity dates ranging from a few days to a year. Treasury Bills are sold at a discount and are worth their face value at maturity. Treasury Bills can easily be sold on the open market prior to maturity, though the price will vary. Treasury Notes are issued with maturities of 2, 3, 5, 7, and 10 years, and earn a fixed rate of interest every six months. They can also be easily sold on the open market prior to maturity.
State/City/Municipal Bonds: States and municipalities regularly issue bonds. Some are designated to pay for certain projects, such as highways or municipal plants. Others are earmarked for general expenses. Terms and interest rates vary, as does the risk level. The major bond rating agencies (Moody’s, Standard & Poor’s, Fitch) typically issue ratings on the creditworthiness of each bond. Tax savings will vary. These bonds can also generally be quickly sold on the open market.
Corporate Bonds: Corporations borrow money using bonds as well. Generally these bonds are not backed by any collateral, making them more risky than many federal, state, city and municipal bonds. Terms will vary, but typically are at least one year; interest rates will vary widely. Bonds are rated by the three major rating agencies into two broad classifications. High Grade (also called Investment Grade) are rated AAA, AA, A, and BBB. High Yield (also called Non-Investment Grade, Speculative Grade, or Junk Bonds) are rated BB and below. High Yield bonds can be particularly risky. If the bond issuer runs into serious financial difficulties, bondholders can lose most or all of their investment.
Money Market Funds and Bond Funds
Unlike bank money market funds, where the yield (interest rate) is set by the bank, money market mutual funds have fluctuating interest rates. Money market funds typically keep their share prices at $1, and can generally be sold very quickly. They invest in government or municipal bonds and are not insured. However, they are considered low risk in most cases.
Bond funds are mutual funds that invest in specific types and maturities of bonds, such as short-term government bonds, long-term corporate bonds, etc. Interest rates will vary wildly, as will share prices. Typically, funds that invest in shorter-term bonds pay lower interest rates and have less price fluctuation. They are not insured. Most mutual funds can be sold relatively easily and quickly. Investors can choose to receive interest in the form of regular checks or reinvest the interest in additional shares.
Rate and Price Fluctuations
The value of bonds can be very volatile, depending upon the overall bond market. The price (not the yield) of many bonds will vary in an inverse proportion to prevailing interest rates.
For example, say you buy a bond for $10,000 with a five-year term and a yield of 3%. Then the Fed raises interest rates, and similar bonds are now yielding 4%. If you want to sell your bond, no one will pay $10,000 for a bond that yields 3% when they could buy one that will earn them 4% for the same money. Your formerly $10,000 bond will sell for less than $10,000 to make up for the lower interest rate.
In general, the shorter the term of the bond the less its value will fluctuate. That’s why the share values of short-term bond funds will vary much less than the share prices of long-term bond funds.
Risk, Return, Liquidity, Decisions
As with most investments, there are several options depending upon your financial goals, tolerance for risk, and timelines. Work with a trusted financial planner to find the combination of risk, return, and liquidity that works best for you.