Last year I was very proud to have been able to save $18,000. At the end of the year I simply wrote a check and instantly paid off my car which was one of the most freeing experiences ever. In the end I realized I should have put my money in a higher interest savings account but at the time I didn’t know anything about them.
These days the interest rates on savings accounts are pretty low. Used to be you could make a 4% return on your money just letting it sit in the bank. In those days it really made sense to hold onto money instead of investing it. Today the rates are much lower but there is still a huge gap between what different banks offer you. Better to have your money earning something for you than next to nothing.
A lot of the people I talk to don’t really know the interest rate on their savings account. I can assure you if your money is sitting at one of the big banks like Chase or Bank of America your interest rate is probably tiny. Today allow me to give you some better options.
How Savings Deposits Work
Before we talk about savings accounts I really need everyone to understand how banks treat your savings deposits. The reason banks even allow you to have a savings account with them is they want to lend your money out. Federal law limits the amount of money the bank can lend vs. how much money they actually have. This lending practice is called leverage.
If I deposit $20,000 the bank may be able to lend out $100,000 or more depending on the amount of leverage that’s allowed. On some financial instruments the leverage ratio is 10:1. I hope you’re starting to understand why banks get themselves into trouble sometimes. The bank will give you an interest rate on your money based on national interest rates but also based on the interest rate they can charge on the money they lend out. They may charge 3.25% on a mortgage and give you .25% on your savings account. This is classically how banks made money.
Of course things have changed. Banks have obscene ways of making money these days but let’s not get into that. Over time banks have gotten more greedy and have offered less and less interest on savings.
If you read the terms on your savings account there will be terms like APR (annual percentage rate) and APY (annual percentage yield). APR is simply the annual rate of interest on a loan/savings account/credit card. APY is the annual rate of interest plus it takes into account compounded interest for the year. Interest may be compounded quarterly or monthly, as with mortgages, or daily, as with many savings accounts. The more often interest is compounded the more different APR and APY will be.
From Investopedia “Annual Percentage Yield-APY”:
For example, suppose you are considering whether to invest in a one-year bond that pays 6% upon maturity or a high-yield money market account that pays 0.5% per month with monthly compounding.
At first glance, the yields appear equal because 12 months multiplied by 0.5% equals 6%. However, when the effects of compounding are included by calculating the APY, we find that the second investment actually yields 6.17%, as 1.005^12-1 = 0.0617.
This is actually a clever way a bank can make it seem like the rate is lower on borrowed money than it actually is . To combat this bias, always compare the APY between savings accounts never the APR.
High Interest Savings
Savings accounts are a pretty standard thing at banks. Odds are you have a checking account and a savings account wherever you bank. The interest rates on savings deposits can vary widely so it’s important to know your interest rate and if it isn’t close to 1% you should change. Unfortunately for us savers right now interest rates are low. A high interest savings account will probably only get you 1.25% at the most. Luckily though the Federal Reserve is going to raise interest rates this year which will have a positive effect in the next few years.
As far as savings accounts go, a high interest savings is the most simple and straightforward account. The next two I’ll discuss are a little more complicated.
Money Market Accounts
This type of account is very similar to your regular high interest savings. The money is highly liquid. You can take your money out whenever you want. The difference between money markets and savings is mainly what the bank can do with your money. With Money market savings the bank may be able to invest your money in CDs or bonds rather than just lending it out. Money Market Accounts also often have a minimum deposit and a limited number of withdrawals per month. However, they will usually have a higher interest rate attached.
A CD or Certificate of Deposit is another type of savings method that is not very liquid. You deposit your money and then the bank promises to give you back your money and then some. Some CDs mature in a year, others in five years it just depends on the one you choose. The advantage of CDs is they have the highest interest rates because they are the least liquid and again the bank can invest your money in more complicated ways. Also some CDs may have variable interest rates but in general the interest rate you earn is a fixed number.
One way that savers use to combat the illiquidity of the CD is to use a ladder. The CD ladder is essentially buying many CDs with different maturity dates. This way you’re not tying up a huge amount of money at one time. Your different CDs will come due whenever you decide, say every six months, and you will have a steady stream of cash.
It’s important to know that for all the accounts mentioned above your money is insured. If you deposit money in a savings account the Federal Deposit Insurance Corporation or FDIC will insure it up to $250,000. All of these savings methods are safe. If you deposit your money you won’t lose it if the stock market tanks.
Part of investing in the future is knowing what your money goals are. For myself I wouldn’t choose to keep a large sum of money in a savings account unless I was planning on using that money in the next five years. In other words, I can’t afford to risk losing that money because I’ll need it soon.
If you have money saved beyond what you need for your regular savings goals I would advise you not to keep that money sitting in the bank because it simply will not earn you much interest in our current financial climate.
These days it seems to me that everyone is in debt. Debt is normal to people and we need to get away from that. It’s time to start making smart money decisions and that can start today with a smarter savings account choice. Get to know your bank’s interest rate and don’t settle for what your “usual” bank will give you.