Did you know that the money you hide under your mattress, in a cookie jar or between the sofa cushions is slowly disappearing? There’s a little leprechaun called inflation running around, and he likes nothing better than shaving a few cents off every dollar you own.
Historically, the U.S. inflation rate is around 2.5% per year. This may not seem like all that much, but just think: savings of $10,000 lying around idly will actually be worth only $7,500 after ten years. (In terms of numbers, it will still be $10,000, but as prices gradually rise it loses some of its value and will only be able to buy $7,500 worth of stuff).
Does this mean that saving money is not worth it? Of course not; growing your wealth over time is, apart from something like winning the lottery, the only way to become prosperous and enjoy a pleasant retirement.
The important thing is to enlist the help of the inflation leprechaun’s natural enemy: compound interest. By selecting the best place to save money and earn interest, you can ensure that your nest egg won’t be eroded by time and the economy. Depending on which you choose, you may even come out ahead over time.
So, where exactly is the best place to put savings? This really depends on your financial needs: with some of the options you’ll find below, getting your money out is as easy as visiting an ATM, while others require a bit more paperwork and/or charge a fee for early withdrawal. While all the investments we describe here are safe, some do carry a marginal amount of risk (and therefore offer a better interest rate). In addition, a couple require you to maintain a minimum balance, while others allow you to invest $100 dollars as easily as $10,000.
Another consideration, no matter how much you plan to save, is the fee structure of each type of financial product: some actually charge you an amount each month just for holding on to your money. Finally, some of these savings options are simply easier to understand than others. All those mentioned here are legitimate, but many people feel more comfortable entrusting their money to someone else when they know exactly how it’s going to be used.
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Sometimes, the most obvious choice really is the best one. It takes only minutes to open a savings account, which you can easily link to your checking account (to automatically set aside 10% of your salary each month, for example).
Savings accounts are FDIC insured, so you’re guaranteed to get your deposit (of up to $250,000) back even if your bank burns to the ground. This peace of mind, coupled with how easy they are to use, make savings accounts an excellent choice for starting your nest egg. Depending on which you choose, you can normally write checks or use the account’s debit card about once a week without incurring penalties – your checking account will still be your go-to option for everyday transactions. Savings accounts are also cheap in the sense that most of them don’t charge monthly fees just for keeping the account open, which is helpful especially if you don’t yet have much money to save.
The downside of ordinary savings accounts is that their interest rates are typically less than 1%. Putting away a few thousand dollars in one of these is therefore a good start, but it’s not worth calling an investment. Importantly, you probably don’t need to build a big, fat savings account while you’re still carrying debt. Once you have enough stashed away to cover any likely unforeseen expense, you’re better off using any extra cash you have to pay down a mortgage drawing interest at 3½% or (definitely) a credit card balance costing you 20% or more each month.
High-Yield Savings Accounts
Almost as simple and convenient is a special class of savings account that often pays 2% interest or more. Depending on the bank, these are also federally insured (and it’s worth checking!). There’s no clear dividing line between one and the other, but higher-yield savings accounts generally require you to maintain an account balance of anything between one hundred and several thousand dollars. If you go below this number, you will probably have to accept a lower interest rate or start paying monthly account administration fees.
Online-only savings accounts are worth a particular mention. Since online “banks” operate with a minimum of staff and don’t need to pay rent on a network of branches, they’re often able to pass these savings on to their customers. However, saving at your usual bank instead may offset this advantage by allowing you to qualify for better interest rates and loyalty rewards. Crucially, your local bank branch is often a good source of free financial advice, while a call center is the best you can hope for with an online organization.
Certificates of Deposit
Certificates of deposit, or CDs as they’re commonly called, are a step up from a savings account. In essence, they let you trade some liquidity – the ability to access your cash whenever you need it – for a higher interest rate.
When you buy a CD, you’re essentially entering into an agreement with the bank to keep a certain amount of money with them for a period ranging from a few months to more than a year. Once that time expires, the bank returns your initial sum plus a bonus equivalent to about 1% per year. The longer the timeframe you select, the better your returns will be.
If, on the other hand, you need to cash out a CD before its maturity period, you’ll be required to pay a stiff penalty fee. In fact, if you need money in a hurry, you may be better off taking out a personal loan, perhaps using the CD itself as collateral.
This limitation of certificates of deposit has led many people to pursue the strategy of laddering. Basically, by taking on several CDs with different maturity dates, you can count on having liquid, spendable cash available at predictable intervals. At that point, you can decide either to reinvest your return to keep seeing gains, or treat yourself to that leather jacket you have your eye on. A CD ladder could look like the following:
CDs are FDIC-insured, so you needn’t worry about taking a loss unless you withdraw your money prematurely. As each depositor causes some administrative overhead for the bank, they prefer larger investments: minimum amounts range from a few hundred to several thousand dollars.
Money Market Mutual Funds
The principle behind a mutual fund is that many small investors can pool their money, giving each of them access to a piece of bigger transactions and allowing them to hire a team of professional money managers. The upshot is that a saver’s risk is reduced through diversification, while their money can still earn a competitive interest rate (at least compared to similarly safe savings options). Money you put into mutual funds is not, however, insured by FDIC, so there is a chance of your balance going down rather than keeping up with inflation and thereby maintaining its value. Though the risk is minimal, this is one factor that shouldn’t be overlooked when you’re deciding what to do with savings. It’s also a good idea to inspect any given fund’s fee structure closely: while savings accounts are often free, most mutual funds charge an annual or monthly fee that can eat away at your earnings.
A money market mutual fund is one that invests very conservatively, meaning that the majority of its money is parked in instruments that carry a near-certain return. Examples of these would be U.S. treasuries and high-grade corporate bonds as described further down below.
Money Market Deposit Accounts
Unlike a mutual fund, a money market account is very much like an ordinary savings account: your capital is backed by federal insurance, you can normally withdraw money by check or debit card, and you earn interest at a stated (though still variable) percentage rate. The key difference is that money market accounts earn more than ordinary savings accounts, as the bank is allowed to invest this money in slightly more risky ways and earn a higher profit.
The only way to make a rational decision between a money market and other high-yield savings account is to check the specific terms and conditions, including whether interest is compounded daily, weekly or monthly. In either case, you will typically be limited to six withdrawal transactions in any month. Speaking in general, money market accounts perform at their best when interest rates are high.
T-Bills and Treasury Notes
As long as the government continues to run at a deficit – as it’s been doing since the late seventies – it has to keep borrowing money, including from taxpayers like you and I.
To make this process more efficient, the government’s obligations to pay back the money it borrows (plus interest) are “sold” at regular auctions. The more demand there is for federal debt, the lower the interest rates offered. This is one of the best places to save money in uncertain times, as the government basically stakes its entire credibility on its capacity to pay back what it borrows. Even during recessions and political upheavals, treasuries’ credit rating usually remains at the top tier for all possible investments.
The major difference between treasury bills and notes are that bills mature in a year or less, while notes may have a timeframe of as long as ten years (and pay the bearer a small amount of interest every 6 months). In practice, the maturity period is less important than it is with certificates of deposit, as treasuries can easily be traded at any time between being issued and maturity. It’s also worth mentioning that any gains from them are exempt from state taxes.
Municipal and Corporate Bonds
U.S. treasuries are probably the best example of one person’s debt being another person’s asset. If Allan borrows $100 at 4% interest from Bob, Bob can sell that IOU to Charlie: Bob now has cash he can spend, Charlie earns 4% on his investment, and Allan doesn’t really care either way. Similarly, companies and cities can also package their debt as securities that can be bought and sold.
Although not quite as highly regarded as T-bills, many of these bonds are pretty safe – the safer they are, of course, the less interest they pay. At worst, the company issuing them may go completely bankrupt. If this risk is significant, we’re no longer really talking about the best place to save money and we’re heading into “junk bond” territory.
Even if preserving the value of your capital is your only goal, you still have a wide range of options in the bond market. Interest rates are fixed, like with CDs, but usually significantly better, with similar penalties if you withdraw your money early. Bonds can also be sold, but depending on what organization backs them, might be a lot more difficult to exchange for cash than T-bills.
As a general rule, the best place to save money you might need within the next five years is in one of the safe vehicles listed above. You won’t see any spectacular returns, but you’re pretty much guaranteed to get back at least as much as you put in, even when adjusting for inflation.
If you’re able to plan for a longer timeframe, however, you can also consider more volatile environments where your money is likely to grow faster – but where this is not a sure thing. The reasoning behind placing riskier bets over the long term but choosing safe short-term investments is simple: nobody really knows which way the stock market will go over the next 12 months. If you put all your money in company shares, the economy takes a dive and you’re suddenly in need of cash, you’ll be forced to take a loss by selling at the bottom of the curve.
In the long run, however – at least according to conventional wisdom – the stock market will always rise, on average faster than bond values or savings accounts. So, to sum up: if you might need the value of your savings in ready cash any time soon, choose a safe, liquid investment vehicle like a money market account or T-bills. If you’re saving up for a retirement that’s still a decade or more off, though, you can consider less stable opportunities. We highly recommend that you seek guidance if this is on your mind: free advice, including what you read in the newspaper, is often worth exactly what you pay for it.
It’s always difficult to overcome inertia, even if this means leaving money on the table. Keeping a lot more than a month’s living expenses in your checking account may be the easiest course of action, but it’s doing you no favors.
Deciding which kind of savings instrument is right for you, and then selecting from the various opportunities out there, does take some time and brainpower. It’s essential that you do so as soon as possible, though: one of the “secrets” of building wealth is to make good decisions today even though you may only enjoy the results several years down the road.
Thank you for reading!