Last year, I introduced my 8-year-old son Gerald to the joys of compound interest when we took $1,000 out of his passbook savings account and invested the cash in a certificate of deposit earning 5%.
That CD will soon mature, so time to do a little financial housekeeping: Do we let the CD "roll over," or see if we can find an alternative that may offer higher yields?
The timing couldn't be worse -- the Federal Reserve has slashed short-term interest rates to 3% from 4.75% last year, when we opened Gerald's account. Savings-account yields typically track the Fed's short-term discount rate, so finding a savings account that yields more than his current CD will be tough. Indeed, if we did nothing and let his CD roll over at his bank right now, the annual percentage yield would drop to 3%.
But choosing the right savings vehicle for Gerald's cash isn't as easy as depositing cash in the account with the highest yield. Finding the right place for his short-term savings means weighing other factors, specifically liquidity and risk.
It's unlikely Gerald will need to spend the $1,025 he has saved in his current CD anytime soon, but I want to keep his savings in a relatively liquid account so that he has to manage his savings regularly in order to get the best returns. And since this is his short-term savings, we need to find an investment with extremely little or no risk of losing capital. (Gerald is already learning a lesson in market risk by watching the roller-coaster ride his target-date mutual fund is taking in his 529 college-savings account.)
To find the best place for Gerald's short-term savings, I wanted to know what other banks were offering. So I headed to rate-comparison Web site Bankrate.com to find high-yielding CDs. The national overnight average yield on a one-year CD is 3.44%, down from 3.84% last week, according to Bankrate. (The biggest drawback to CD is liquidity -- you'll pay an early penalty for taking money out before the maturity date.)
A quick search found 12 banks offering CDs with APYs of between 4.02% and 4.61%, but there was a catch: Most required minimum deposits of $1,500 or more. Out of the 12, just two banks offered the most-attractive rates with low balance requirements: GMAC Bank (4.20%, with a $500 minimum balance) and Third Federal Savings and Loan (4.00%, $500 minimum).
There were also differences in how frequently the interest was applied -- CDs may compound daily, monthly or quarterly. The account that compounds interest most frequently generates the highest returns. For example, Gerald's $1,025 would grow to $1,066.62 in a 12-month CD applying compound interest quarterly, while a CD with interest that compounds daily would grow to $1,066.83. (Not much of a difference, I know -- but in time those pennies will grow to big bucks.) The GMAC CD compounds interest daily, while the Third Federal CD compounds quarterly, making GMAC's CD the better deal.
Next I checked out high-yielding savings accounts. Rates here were generally higher than CDs, though they'll likely move lower in the next few weeks, in line with short-term interest rates. The good news here is that some banks offer attractive rates with very low minimum-balance requirements. A quick Bankrate search found five banks offering APYs at 4.5% and higher, with Los Angeles's UnitedBank leading the pack with a yield of 5.20%. (Minimum investment: $1,000.)
Online banks, such as SavingsSquare.com and Igobanking.com, also offered yields above 4.5%. But online savings accounts come with their own headaches. Many banks don't allow check writing, though most will allow customers to link their savings accounts to checking accounts so they can transfer money electronically.
You'll also pay additional fees to use other banks' ATMs to make withdrawals, and other online banks charge fees for making frequent withdrawals. I like the idea of an online savings account for Gerald, though: We can check in on it periodically so he can see his savings grow in real time, rather than wait for his CD to mature.
I ruled out investing his savings in money-market accounts -- the accounts with the best rates have minimum balance requirements far higher than $1,000. Money-market accounts differ from money-market mutual funds in important ways. Money-market accounts are insured by the Federal Deposit Insurance Corp., up to $100,000. Money-market mutual funds aren't insured, though they try to make up for the higher risk by offering greater yields than money-market accounts and lower minimum-balance requirements.
Moreover, most money-market funds are extremely stable and invested in conservative investments, such as U.S. Treasury bills and bank CDs. The top taxable money-market fund yields are currently being offered by Vanguard Prime at 4.36%, Fidelity Cash Reserves at 4.31% and Thrivent MMF at 4.29%, according to money-market tracker iMoneynet.com. Money-market funds also don't come with requirements such as minimum balances and withdrawal limits.
With interest rates declining, tax-free money-market funds often earn higher returns as well. These funds typically invest in tax-exempt entities, so you don't pay taxes on any interest earned. Two of the highest-yielding tax-free funds are Alpine Municipal MMF, with a tax-free yield of 3.05%, and Vanguard Tax-Exempt MMF, with a tax free yield of 2.98%. But since Gerald doesn't earn enough income to generate a tax bill, we'll look for higher rates elsewhere.
We could invest in Treasury bonds, one of the most-secure investments around. The yield on the EE savings bond is 3.00%. I bonds, which earn interest and protect against inflation, offer an even more-generous 4.28%. (Both rates are effective through April 30.) We'd pay a price, though, in terms of liquidity -- you need to hold the bonds for a year or more or pay a penalty. If we were willing to take on a bit more risk, we could consider a low-cost bond fund or a bond exchange traded fund (ETF). But a chunk of Gerald's earnings would be eaten up by fund-expense fees and trade commissions.
So it's back to the banks. Our decision basically comes down to this: Should we lock in rates now in a CD and hope rates don't suddenly move higher, or choose a high-yielding savings account and hope competition for deposits forces banks to offer attractive rates? With the U.S. economy in flux, and Wall Street shaken by the housing-market swoon, the Fed seems unlikely to raise rates in the near-term. Given the current rate environment, we're going to be conservative and go with the CD. I'll check back in when the new CD matures and see if locking up Gerald's savings was the right move.
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