Big Idea ? Savings Tools
Objectives ? Readers will be able to ?
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Distinguish between the characteristics of each savings tool.
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Describe the return and risk of various savings tools.
The Downside of Today?s Low Interest Rates
The Federal Reserve has promised to keep short-term interest rates, and its monetary tool the Fed Funds rate, between 0%-0.25% through 2014. Today?s interest rate environment is great for trying to spur economic demand and help individuals secure a low cost mortgage or car loan.? But, it is equally as bad for the return and interest rates savers are earning on their cash balances!
You want to earn a rate of return on your savings that at least outpaces inflation. ??Consumer Price Inflation (CPI) measures the price of a basket of goods and services.? An increase in the CPI implies there has been an increase in the goods and services that you have to pay for on a regular basis.? If you do not outpace inflation, you are losing money as your purchasing power is decreasing.?? For example, if inflation is rising by 2%, and you are earning 0.2% on your savings account, your purchasing power is going down by 1.8% each year.? In a sense, you are making yourself poorer with each passing day.
?The savings account interest rates surveyed averaged an annual percentage yield (APY) of just 0.20% in the first quarter of 2012,? according to a survey in the fourth quarter of 2011 by MoneyRates.com.1? Retirees, who rely on savings accounts and fixed income investments to pay a steady stream of interest in retirement, are suffering from these low interest rates.? In this post, I discuss savings tools options, and provide resources that will help you maximize the APY on your savings balances.? Though it is not the most exciting portion of personal finance, it is important.? And, when interest rates normalize to the historical average, knowledge of the different savings tools will help you increase your net worth.
A Few Options You Have For Your Savings
When I speak about savings, I am referring to money that is not spent on consumption and that you are setting aside for emergencies and future use. Before you determine the product for maximizing the Annual Percentage Yield on your savings, you have to understand the product options and the risk versus the potential return.? In the table below, I highlight the different type of savings tools along with their characteristics.?? All of the tools are considered ?low risk,? and all except Money Market Funds are FDIC insured.? The FDIC (Federal Depositor Insurance Corporation) and NCUA (National Credit Union Association) insure individual accounts against loss up to $250,000, and joint accounts up to $500,000.? Though Money Market funds are not FDIC or NCUA insured, most of these products are considered low risk and deserve some attention.
There is no free lunch and you should know that if you are receiving a higher APY for a product, in most cases your money is more restricted (restrictions on transactions, minimum balance requirements, etc.) or you are taking more risk (credit, inflation, or other risk). ??See the description, characteristics, and pros and cons of the products below:
| Type | Description | Pros | Cons |
| Savings account | An account to hold money not spent on current consumption |
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| Certificate of Deposit (CD) | An insured interest earning account with restricted access to the funds. The deposits have to be held for a certain length of time, ranging from a few days to several years. |
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| Money Market Account or Money Market Demand Account | Offered by most depository institutions, and pays a higher interest rate for maintaining a higher minimum balance |
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| Money Market Fund | ?A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a ?money market deposit account? at a bank, money market funds are not federally insured.?2 |
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The Reason You Earn A Higher Return For Some Products
Evaluating the tools above, it is important to understand why the different savings tools allow you to earn a higher interest rate.
Certificate of Deposit ?
What you get (the return) - A bank is willing to pay you more in interest because you have committed your money to the institution for a longer period of time.
- It is more predictable for the institution, as they have locked up your money for a fixed period of time.
- You, and the financial institution, are taking risk for a longer period of time.? For example, interest rates can go up or down during the term of the CD.
- In return, the depositor earns a higher interest rate.
- The longer your money is locked-up, typically the higher the APY. ?Ally was recently advertising 1.04%, 1.095, 1.30%, and 1.69% for 1 year, 2 year, 3 year, and 5 year CDs, respectively.
Why you get the return - For the higher return, you and the bank are also taking higher risk:
- You are getting a higher rate than a savings account, but you also risk earning a below market interest rate if interest rates rise.
- If you lock-in a 5-year CD today for 1.69%, and next year inflation picks-up, the Federal Reserve may start raising the Fed Funds rate aggressively (1.5% to 2% in a year).
- Given short-term interest rates tend to track the direction of the Fed Funds rate, savings accounts could start paying 3-4% again.
- Unfortunately, if you bought a 5-year CD, you will be locked in at close to the lowest historical rates ever ? 1.69% for 5 years!
Money Market Account (Money Market Deposit Account)-
What you get (the return)- ?For maintaining a higher balance, $10,000 in some cases, you can typically earn a higher interest rate in money market accounts.
- A financial institution likes when they get a larger portion of your cash.
- In return, they pay you an interest rate (typically higher than a traditional savings account) and loan money to someone else at a high interest rate.
- The more money you have given them, the better for both you and them relative to a traditional savings account.
- Recently, Bank of America was paying 0.15% on balances of $10,000 or greater in a Money Market Account versus 0.05% for a standard savings account.3
- In today?s low rate environment 0.10% is a trivial benefit, but it is 3 times as great as the traditional savings account.? When interest rates normalize, the difference should be more pronounced.
Why you get the return ? In return for a higher interest rate, you have to not only maintain a higher balance, but also the bank sometimes limits the number of withdrawals per month.
Money Market Fund ?
What you get (the return) ?
- Your money is liquid, meaning you can take it out relatively quickly (1 to 2 days).
- Typically, you can earn a higher interest rate than savings accounts and other FDIC insured savings tools.
- The rate will move with overall short-term market rates, and as the rate rises you can participate in the rate increase more quickly.
Why you get the return ?
- The account is not FDIC insured (but is relatively low risk).
- These funds typically invest in short-term U.S. Treasuries and short-term commercial paper, and other investments with average maturities less than 90 days.
- The investments do have risk, but are considered low-risk. (You must read the prospectus on the fund that you buy.)
Tools for Maximizing The Return on Your Savings
Regarding the FDIC options ? Savings, CD, and Money Market accounts ? ?a great resource is MoneyRates.com. ??The site allows consumer to search for the best APY in each respective category. ??You can use the site to research and compare the APY institutions are offering versus what you are currently earning on your savings.?? Maybe you will find a more lucrative, but similar risk option.?? Unfortunately, in today?s low interest rate environment, it is going to be hard to earn a significant return in most cases. When the Federal Reserve reverses its low-interest rate policy, it is a tool that will be more useful.
Is a good idea to keep at least half of your 8-12 month emergency fund in a savings account, but for excess savings (money you are not using for consumption or investing), I prefer both Money Market accounts and Money Market Funds.?? There are many money market funds, and you have to do your research.?Fidelity?is a great place to start.
Regardless of what savings tools you choose, and I recommend you have a balance, make sure you ask yourself the appropriate questions:
- How do these accounts differ?
- What is the APY?
- For that APY, what additional risk are you taking?
- Are there minimum balance requirements, monthly service fees, etc.
- How many withdrawals are allowed?
- Is your money readily available?? Or, are there early withdrawal penalties?
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Upcoming post-
The Importance of Investing ? Moving from Savings to Investment
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?Assessment (Answers in tomorrow?s post)-
1.? What is the risk of today?s low interest rate environment?
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2. What is the difference between a money market account and a money market fund?
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3. Use the tools provided to research current savings rates.?? Compare the APY you are earning on your existing savings with current market APY.? Determine a plan of action to maximize your return for the level of risk.? Please share any information that will help our readers in the comments and on the Personal Finance Teacher page.
Answers to yesterday?s questions-
1. What ?hidden? benefit of does a 401(k) plan (or tax-deductible retirement plan) offer?
You lower your yearly tax bill by contributing to a tax-deductible retirement plan.?
2. List a few additional benefits to paying yourself first through a 401(k).
You can establish an emergency savings fund, invest and grow your money, and potentially earn a company match via a 401(k) plan.
3. Look back at your budget.? Can you afford to contribute more to your 401 (k) by paying yourself first?? If you have ideas for how you squeezed more savings out of your budget, please share them in the comments or on the Personal Finance Teacher Facebook page.
4. Action item- if you are not currently contributing to your retirement plan, obtains information to learn about the company?s plan, matching contribution, and other features.
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Sources-
1- Retrieved from http://www.money-rates.com/research-center/americas-best-rates/2012-Q1.htm
2 ? Retrieved from http://www.sec.gov/answers/mfmmkt.htm
3 ? Retrieved from?http://www.bankofamerica.com/deposits/growth-money-market-account.cfm
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