Risk-free Investments – CDs and Savings Accounts
Saving money for your retirement in IRAs, 401ks, and other investment accounts is extremely important. However, saving some cash for unforeseen expenses is also a must. You should keep three to six months of your salary in a savings account in case you lose your job or have an accident that your insurance doesn’t cover. Liquid investments – such as certificates of deposit (CDs) and savings accounts at FDIC-insured banks – are a good way to earn interest on savings that you may need to access in the near future. These are risk-free investments, which means you won’t lose your principle investment like you could with stock, bond, or mutual fund investments. This article helps answer the following questions about risk-free investments:
- What’s the difference between a savings account and a CD?
- Which banks have high interest rates?
- Which risk-free account is right for you?
Savings accounts and CDs are the two safest ways to save money and earn interest without risk. The Federal Deposit Insurance Corporation (FDIC) insures 100 percent of your deposits in either of these accounts up to $250,000 per bank. Most banks in the United States participate in the FDIC program, but you should always check before opening an account at a new bank. There are a few key differences between savings accounts and CDs:
- Savings accounts –A savings account is a bank account in which you keep cash; however the bank doesn’t leave your money sitting in the account. Instead, they invest it or loan the cash to other people. The bank pays you interest to compensate you for the use of your money. A savings account’s interest rate isn’t guaranteed, which means the bank can raise or lower it at any time; however, you’ll always earn some interest on money in a savings account. Even though the bank is using your money, you can still withdraw it at anytime. Savings accounts have one major limitation – you can only make six withdrawals per every monthly statement cycle, and some banks have even stricter withdrawal limits. Only deposit money in a savings account if you know you won’t need to make frequent withdrawals. Many banks also charge a fee if savings dip below a minimum balance. Choose a bank that doesn’t have a minimum balance requirement if you know your savings account balance will fluctuate.
- Certificate of Deposit – A Certificate of Deposit (CD) is a savings product that typically has a higher interest rate than a savings account but much less liquidity – you can’t withdraw your money whenever you want. When you open a CD, you make a single deposit that will remain in the bank for a specified amount of time – CD terms range from three months to several years. In return, the bank guarantees you a set interest rate for the entire term of your CD. This is a good deal if you open your CD when interest rates are high; it’s not a great investment if interest rates start to go up while your money is stuck in the CD. A CD is a good choice if you have a chunk of money that you won’t need for awhile at a time when interest rates are high. Consider CDs that have longer terms because you’ll typically earn much higher interest rates with long-term rather than with short-term CDs. There are some CDs that don’t follow these rules and may have variable rates or other exceptions. Read the terms and conditions very carefully before investing in any financial product.
Most banks offer savings accounts and CDs, but not all accounts are created equally. Spending a little time searching for the best interest rate can pay you major dividends down the road. In general, online banks have higher interest rates than traditional banks. Traditional brick-and-mortar banks have high overhead costs – building maintenance, on-site personnel, etc. – so they can’t afford to offer the high interest rates that online banks can.
Any bank that has many physical branches is a brick-and-mortar bank – well known brick-and-mortar banks include Chase, Bank of America, and Citibank. These banks are great choices for checking accounts but often pay very low interest rates to savings account holders. Some brick-and-mortar banks offer interest rates as low as .1 percent right now. Compare that with an online bank like ING Direct, whose Orange Savings Account is currently at 1.4 percent. Assuming interest rates stay constant, your $1,000 deposit will earn one dollar in annual interest at a brick-and-mortar bank versus $14 at an online bank such as ING.
Online banks also offer CDs with higher rates than brick-and-mortar banks. A six month CD at ING yields 1.15 percent interest while a similar CD at a brick-and-mortar bank yields only .25 percent.
Ally Bank, ING Direct, and HSBC Direct are a few FDIC-insured online banks with competitive interest rates on savings accounts and CDs. You can find interest rates at any bank’s website, or compare rates at several banks at the same time. Look for the Annual Percentage Yield (APY) when comparing rates among banks. The APY is the percent of interest you’ll earn if you leave your money in the account for a full year. Also look for the Compounding Method (CM), which is a description of how frequently a bank compounds interest – the CM may be yearly, quarterly, monthly, daily or continuous. The CM is important because interest that’s compounded frequently earns you money faster – daily or continuous compounding is best. You’ll also notice that rate comparison sites list Money Market Accounts (MMAs) along with CDs. Although MMAs are considered to be low-risk investments and often offer a competitive interest rate, they aren’t insured by the FDIC.
Many online banks have great customer service, but it’s all done via the phone or Internet. If you prefer to interact with a banker face-to-face, a brick-and-mortar bank may be a better choice even if it has a lower interest rate.
Thanks to FDIC insurance, putting your money in a savings account or CD is always risk-free, but you still have to decide which type of account is right for you. First, identify your savings style in order to choose the right account type. Opt for a savings account if you plan to set aside some money each month. Open a CD if you have a hefty sum of money that you won’t need for awhile, but remember that you can’t add money to existing CDs. A good strategy is to start with a savings account and then open a CD when your savings reaches a sizeable balance.
Next, you’ll choose a specific account that best meets your needs. Here are some important considerations about savings accounts:
- Withdrawal convenience – It can take two to three days to transfer money from an online savings account to a checking account at a different bank. If you expect to make regular withdrawals, open a savings account at the bank where you already have a checking account.
- Interest rates – Always evaluate interest rates when choosing a savings account. Select a bank that has a high interest rate relative to its competitors. A slightly higher APY can lead to significantly greater earnings over the long-term.
- Minimum balance requirements – Think about how much money you’ll keep in your savings account. Choose an account with no minimum balance requirements if you may need to withdraw most of savings in the near future. Check into premium savings accounts at your bank if you’re confident that you’ll always maintain a sizeable balance. Savings accounts with minimum balance requirements typically offer more attractive interest rates.
Here are some things to think about when choosing a CD:
- Early withdrawal fees – You have to pay a fine if you withdraw money from a CD before its term expires. If you’re attracted to CD rates but nervous about tying up your money, consider the No Penalty CD from Ally Bank. This CD has slightly lower rates but doesn’t have early withdrawal penalties.
- Interest rates – Take a look at interest rates. As of August 2009, many savings products have low interest rates. Opening a long-term CD right now probably isn’t the best choice because interest rates may go up before the term ends. Choose a short-term CD – six to nine months – or a savings account.
- Minimum investment requirements – Many CDs have minimum investment requirements, which can range from a few hundred dollars to thousands of dollars. CDs with minimum investment requirements typically have higher interest rates, but you can usually find a competitive interest rate among CDs without minimum requirements.
Savings accounts and CDs may earn money more slowly than many stock market investments, but they’re much safer. Saving money at an FDIC-insured bank can give you the financial security to deal with unexpected life events or make substantial purchases without racking up credit card debt. Choose the account type that’s right for you and watch your money grow.
By: Jessica Bayliss
Jessica Bayliss is a freelance writer specializing in finance and education. She has degrees from the University of Illinois and Texas A&M-Kingsville and is still learning all about what college forgot.