It's a good thing to start a savings account. But where earning interest is concerned, there are much better ways to do it.
In the last column, we talked about earning interest. As you may recall, we did away with that term and described this form of investing as money rental. The interest is merely the rental fee you’re paid for renting out your money. To make this explanation simple, I used a plain old bank savings account as the example.
While a regular savings account is the simplest form of money rental, it’s not the best way to make money at it. Banks don’t pay high interest on such accounts, and when you consider inflation, the rate can be pretty dismal. Indeed, when inflation is high, you can actually lose money in a savings account: Let’s say a loaf of bread that cost a buck last year now costs a nickel more. The $100 you put in the account last year could have bought a hundred loaves. But after a year of interest you’ve now got $103 in the account — enough to buy 98 loaves. Money’s value is in what you can do with it . . . like eat. When you can’t do as much with it as before, you’re dealing with inflation.
Today in the U.S., most savings accounts pay less than what inflation takes away. But they still have their uses. If you’re stowing away money for a bigger investment in your immediate future, or need a safe place to keep some money in case of an emergency, or you’ve just now committed yourself to saving up money and need a simple place to start, a savings account is a very good place to do it. But as soon as you’ve got $500 to $1,000 in your account, you need to be ready to look for better money-rental opportunities.
Banks pay higher interest on accounts with higher balances — the more you’re willing to rent to them, the higher the rental rate they’re willing to pay. The most popular higher-yield opportunity they offer is called a money-market account. Unlike a regular savings account, a money-market account’s interest rate varies with the economy. If interest rates in the money market go up, the bank raises your interest; if they go down, so does yours. But in most cases, your rate will still be higher than that of a plain old savings account.
The fine print: Money-market accounts are for money that’s meant to stay there. In general, you’re allowed up to three withdrawals per month; anything over that will cost you a penalty. And you need to keep a significant balance in the account, typically $1,000, $2,000 or more. If you go below the minimum, watch out: The penalty can erase all your gains. Don’t open a money-market account unless you know you can maintain that minimum balance no matter what.
Certificates of Deposit
CDs are another higher interest deal offered by banks. They’ll pay you a higher interest rate in exchange for your promise to let them keep the money for a specific term — three months, six months, a year, even more. Which means that you can’t take money out before the term ends, or matures. OK, you can, but it means closing the account and paying the bank a big fee for your broken promise.
Because a CD locks up your money for the term, you have to be careful about when and how much you invest. If interest rates are rising, choose a short term agreement, then reinvest at a higher rate when the CD matures. If interest rates are falling, go for a longer term — you’ll still be getting yesterday’s higher rate long after it’s no longer available for new investments. Some people use CDs to keep them from spending away money that will be needed later. For instance, if you’re saving up to buy a car or make a big tuition payment next year and want to avoid the temptation of spending that money on something else in the meantime, lock it up in a CD that matures just before you need the cash. It will be free again the moment you need it — but not before that.
If you invest in a CD, be sure to mark the maturity date in your calendar. When it matures, the bank gives you a limited time period to decide what to do with the money. If you don’t tell them, they’ll roll over the account into another CD with the same term at the rate they’re offering at that time. Then you must wait till the new term ends to get to it again.
By the way, many brokerage houses and investment firms offer money-market and CD accounts that pay higher rates than banks. The difference is that with a bank, your money is insured for up to $100,000, so if the bank goes bust, the government picks up the tab. Just another example of the inverse relationship between risk and reward.
Other Rental Schemes
There are plenty of other ways to rent out your money, including loan-sharking and bail-bonding. Oh, and the regular bond market.
A bond is an IOU: When you buy one, you’re lending your money to the bond issuer in exchange for a promise note stating how much you’ll be paid back, when you’ll be paid, and how much interest you’ll earn. Though companies issue lots of bonds, you generally hear more about government bonds: savings bonds, school bonds, city bonds — and in your grandparents’ day, war bonds. That’s because when a government agency needs to raise a big stack of cash, it can’t issue stock. So it issues a bond, then counts on future taxes and other revenues to cover the interest on the borrowed money.
Bonds are a very popular form of investing, but since IOU notes are not the kind of thing that make the evening news, you don’t hear about them much. Nor will you hear much about them here. Most bonds pay simple interest: Instead of adding your interest to the IOU like a bank does with your savings account, the issuer sends you interest checks each year. That’s great if you’re retired with a huge stack of bond investments; the interest checks can be a key source of income.
But right now, while you’ve got other sources of income (or will on the other side of graduation), and are trying to build a nest egg, you want to keep every dollar hard at work, earning more dollars. There are other types of bonds such as U.S. Savings Bonds and zero-coupon bonds that pay their interest all at once, but the former have a 10-year maturity and don’t have high yields, and the latter require some serious study and careful investing on your part in order to make money in the short run. So I won’t go into all the gory details on bonds.
A Rental Strategy
So what does all this mean for you right now? If you’re still working your way up to your first $500 or $1,000, keep the money in your safe, simple, low-yielding savings account. But keep your eye on the future . . . and create a sensible savings plan to get you there. Make a deposit with every income check you receive. When you’ve got enough saved up to open a money-market account, put most of your savings there. And if you can afford to lock up some of that money for a while, open a CD.
Well, here we are at the end of another column, and still not a word from me about the stock market or mutual funds. Stay tuned, we’ll get there soon.
Copyright 2002 Todd Temple. All rights reserved.