When you make the decision to start saving, you’ll find you have some options in addition to a traditional savings account. You can also choose a money market account, a money market fund, or even certificates of deposit (CDs). Each has its unique features and depending on the purpose of the savings account, one may be a much better option than another.
Most people are familiar with a standard savings account. Money you deposit in a savings account pays variable interest that rises or falls along with the Prime Rate. Interest may be compounded daily or monthly, depending on the bank’s policy. A savings account does not provide checking privileges, so accessing your funds requires a withdrawal or a transfer.
A money market account is similar to a savings account but often pays a higher interest rate than a savings account and often offers limited check-writing ability. Expect to find higher minimum balance requirements than with savings accounts, although minimum requirements vary by bank from as low as $1 to as high as $1,000. The funds in a money market account are used to invest in a portfolio of short-term securities and the bank pays interest earned from these investments.
A money market fund, while easily confused with a money market account, is a mutual fund that invests in interest-bearing bonds of various types. Federal regulations require money market funds to invest only in securities that are short term and of high credit quality. Even with regulatory safeguards in place, it’s possible to lose money on a money market fund investment, a lesson learned by some investors during the housing crisis.
Money market funds strive to maintain a net asset value (NAV) of $1. Occasionally, although rare, a money market account can fall below $1 NAV, called breaking the buck, in which case some of the original investment is gone and investors will lose money on the fund.
Many funds offer same day settlement, giving you fast access to money, and many funds offer check-writing ability as well.
A certificate of deposit is a savings account with a fixed interest rate and a fixed date of withdrawal, also called a maturity date. Generally, a longer-term CD provides a higher interest rate than a shorter-term CD, but this relationship can become inverted when interest rates are rising – and your money is already locked up in a longer-term CD. Typically, you can expect to pay a penalty or fee to take your money out of a CD before its maturity date, a process called breaking a CD.
How you intend to use your account will help guide your decision on which type of account to use. In some cases, none of the account choices covered in this chapter will be the right choice to meet your goals. For example, if you primary goal is retirement savings, you’ll probably want to focus on a traditional IRA or a Roth IRA. While some options are considered investment accounts as opposed to savings accounts, they may provide the type of performance you’ll need to grow your balance the way you’d like.
If your goal is to build an emergency savings, flexibility may be key. Imagine a situation where you need to access your savings, but you can’t because of account restrictions. This situation can happen with some types of accounts – or in some cases you may have to pay a penalty to access your money. There are benefits and tradeoffs for each type of account so it’s important to understand the rules before you commit your money to one type of account over another.
We like to think of banks and financial institutions as safe places to keep our money. In general, this is true, but sometimes banks find themselves on the wrong end of a financial crisis, as happened during 2007-2009 and as has happened at other times in the past. During the housing crisis, the federal government increased the amount of insurance available for certain types of accounts from $100,000 to $250,000. If the account has two account holders, the maximum coverage limit is increased to $500,000, or $250,000 per account holder.
If you choose a savings account, a money market account, or a CD, your deposit is insured. If you choose a money market fund, however, your balance is not insured. Money market funds are investment accounts and Federal Deposit Insurance Corporation (FDIC) coverage doesn’t apply.
Choosing to open an account with a credit union instead of a bank brings similar safety guarantees. Credit union deposits are insured by the National Credit Union Insurance Fund, or NCUSIF, which mirrors the coverage provided by the FDIC.
FDIC or NCUSIF insurance limits are per account holder and per account. The main limitation to be aware of is that not all financial products offered by banks are insured. Notably, mutual funds (including money market funds), stock or bonds, annuities, and life insurance policies are not covered by FDIC or NCUSIF insurance.
Some types of accounts have a required minimum to open an account or a minimum balance that must be maintained. This can be a consideration as well, particularly if you suspect you may need all of most of your savings at some point.
Because these accounts are designed for savings or used as a place to park money temporarily, it’s important to consider the availability of your funds. CDs, for example, aren’t a great choice for savings if you think you’ll need the money at some point. Because there’s a penalty for breaking the CD by withdrawing your money before the CD matures, you might lose money with a CD if you need the funds early.
Savings accounts, as you might expect, don’t offer access to check-writing ability. This means that to access your money, you’ll need to withdraw the funds or transfer the funds to an account the supports check-writing. Money market accounts, by comparison, often provide limited check-writing ability, which allows you to avoid transfers in many cases.
Regulation D, a federal banking regulation, limits the number of withdrawals or transfers you can make for some account types to six transfers or withdrawals per month. If you exceed this limit, the bank can charge a withdrawal fee or may even close out the account or convert the account to a checking account. Regulation D applies to both checking accounts and money market accounts but does not apply to money market funds because they are investment accounts as opposed to banking accounts.
Money market funds are not regulated by Regulation D but many money market funds limit check-writing ability to withdrawals of $500 or more.
Regardless of the account type you choose for your savings, withdrawal limitations force savers to think ahead whenever possible to minimize the number of outbound transactions on the account.
If you’ve checked the interest rates for any of these savings vehicles lately, you’ve probably noticed that the rates seem low – and by comparison to historical returns on broad stock market indexes, interest rates on accounts geared toward savings are quite low. Many banks are paying under 1% for savings accounts, with online-only high-yields savings accounts paying just over 2%. By comparison, the S&P has returned an annualized average return of 10% since its inception in 1928.
Because interest rates are low for interest-bearing accounts, it may make sense to limit the amount of money you keep in savings accounts, money market accounts, money market funds, or CDs. The intent of these accounts is to provide safety, but the expense is long term growth. If you’re saving for retirement, there are better ways to accomplish this goal. However, if you’re simply building your emergency savings, a savings account often offers the most flexibility if you need access to your money, while a money market account or money market fund may provide a slightly higher return.
Inflation refers to the rising cost of goods and services over time. In a given year, inflation can be either positive, meaning prices went up, or negative, meaning prices went down. While there have been years where inflation was negative, the trend is toward increasing inflation, with the average annual inflation rate since 1913 at 3.15%.
If you’re saving money in a low interest savings account or similar type of account, the return on your savings might be around 2%, for example, at current interest rates. If inflation averages over 3%, you’re losing money to inflation, even as your account balance grows on paper. In simple terms, the money won’t buy as much next year, and the interest earned isn’t high enough to bridge the gap.
Because it’s likely that a savings account or money market account is losing money to inflation, you’ll want to consider how much you want to keep in your savings compared to how much you might want to move to a more aggressive investment that can outrun inflation. Once you’ve reached your savings goals, think about other options.
Any type of savings account provides a better return than keeping the money under your mattress or in the cookie jar, both of which provide zero return, but while interest rates are low, consider other options once your savings goals are met.
Interest rates are only part of the story when choosing an account. Many types of accounts come with a variety of fees that can chew away at your savings. Among the most common fees is a maintenance fee which often applies to savings accounts with a balance of under $300 or to other types of accounts but often with a higher minimum balance required to avoid maintenance fees.
For example, many banks allow you to open a savings account with a $25 deposit. However, many of these same banks charge a $5 per month maintenance fee for the account if your balance is under $300. A small savings balance may only generate a few dollars per year in interest but may cost $60 per year in maintenance fees. You may be better off saving cash int the cookie jar until you reach the minimum balance required to avoid maintenance fees. Alternatively, inquire with local credit unions which may have a less aggressive fee structure – or no maintenance fees at all.
Regardless of the account type you choose to house your savings, the goal is to keep your savings separate from your checking account and out of harm’s way. If your savings only exists as extra money in your checking account, it’s more likely to be spent, either accidentally or simply because it feels like a surplus. Your savings accounts really are a surplus, but it’s money that’s essential to have in the event of an emergency and to avoid using credit to navigate a cash crunch.
Once you’ve opened an account, consider using automatic transfers to fund your savings account, money market account, or money market fund each payday. By paying yourself first, the money is safe from spending and kept in a separate account and can serve its intended purpose of keeping your household emergency-ready.