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Savings Accounts

Maintaining a portion of your assets in cash is essential to efficient money management. Savings instruments provide some measure of liquidity while preserving principal at a guaranteed rate of return.

How are interest rates determined?

When you deposit money in a bank, you are lending the bank your money. The bank uses that money to lend to others. Interest is what the bank pays you for the use of your money to make loans. Interest is calculated as a percentage of the amount deposited.

Interest rates are largely determined by the short-term interest rates set by the Federal Reserve to maintain economic stability. The federal funds rate, as it is called, is the rate at which institutions lend money overnight to another institution.

What is the difference between "rate" and "yield"?

Annual percentage rate (APR) and annual percentage yield (APY) are often both quoted in advertisements. "Rate" is the stated interest rate on the account. "Yield" reflects the compounding of the interest paid. If an account pays interest annually, its APR and APY are the same. But if interest is paid more frequently than annually, the APY will be higher than the APR.

What are the different types of savings accounts?

The two main types of savings accounts are "passbook" savings accounts and "statement" savings accounts. With a passbook savings account, the customer records transactions in a booklet provided by the bank. With statement savings accounts, the bank sends the customer a monthly or quarterly statement reflecting transactions. Both usually offer low or no minimum balance requirements, have low fees and provide a low interest rate.

I would like to put away some money that I do not need to access for a while. Would certificates of deposit make sense?

Perhaps. Certificates of deposit (CDs) lock up your money for a set period of time, but you earn a higher return than a savings account as a result.

CDs are FDIC-insured products, issued in any denomination, with a specified interest rate and a fixed maturity date, usually from 3 months to 5 years. CDs carry a penalty for withdrawing funds before the maturity date, often 3 months of interest. The longer the term of the CD the higher the interest rate will be. The interest is not paid until the CD matures.

CDs used to be fairly straightforward products. They paid a fixed rate of interest on a fixed sum of money for a short to intermediate time period. Today, CDs can have special features, including variable rates and long-term maturities.

Some CDs have "call" features. That is, the issuing bank has the right to terminate, or call, the CD after a certain period of time if interest rates fall. In that event, you will get your original deposit and any accrued interest, but if you want to buy another CD, you will be shopping for one in a lower interest rate environment.

Many brokerage firms now sell CDs as well and sometimes offer higher interest rates than banks. These are referred to as "brokered CDs."

What are "money market accounts"?

A money market account is an FDIC-insured deposit product that acts as a hybrid between a savings account and a checking account. Money market accounts pay a higher interest rate than a savings account, require minimum balances, often charge a monthly service fee and have limited check-writing features. The interest rate is determined by the bank and usually adjusted weekly.

How much do I need to open a money market account?

Money market accounts require a minimum balance of between $500 and $2,500 on average.

I keep a hefty balance in my checking account. Should I use a money market account instead and earn a higher rate of return?

Probably not. By law, you are only allowed to make six withdrawals and transfers per month. The transactions must be overdraft protection transfers, automatic bill deductions, wire transfers or online banking transfers. You are usually limited to writing only three checks per month. Some banks require checks be made in an amount above $500.

Are money market funds the same thing as money market accounts?

No, but they are very similar. Money market funds offer many of the same features as money market accounts, but money market funds are not FDIC-insured deposit products. Rather, they are mutual funds that invest in short-term corporate and government debt. The interest rate paid by a money market fund is determined by the underlying securities.

Money market funds are usually sold by mutual fund companies. When comparing rates, keep in mind that money market funds charge annual management fees and expenses, which reduce your return.

While the FDIC does not insure money market funds, they are considered to be very safe because they invest in high-quality securities.

So which is better—a money market account or money market fund?

Many people make the decision based on convenience. If you need to transfer money between your money market and your other bank accounts, then a money market account might make the most sense. If you plan to transfer money between your money market and your other investment accounts, such as mutual funds, then a money market fund might be the best choice.

Which one pays a higher yield—a money market account or money market fund?

It varies widely, but in general, money market accounts tend to offer higher rates. Because money market funds invest in similar types of investments, the rates those funds pay tend to be fairly close together. There is much greater disparity between the rates money market accounts pay because banks are not limited by the rates of the underlying securities. Banks are able to pay whatever they want, and they are trying to compete with one another for business by offering the most attractive rate.

What are savings bonds?

The U.S. Treasury Department issues securities called savings bonds. While not FDIC-insured, savings bonds are backed by the full faith and credit of the United States. Your principal and earned interest are fully protected.

The Treasury Department does not charge fees to buy or redeem savings bonds. Paper savings bonds come in denominations of $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000.

TIP: You can buy savings bonds online at TreasuryDirect at www.treasurydirect.gov.

Earnings from savings bonds are exempt from all state and local income taxes, and you can defer federal income taxes until the bonds mature or you redeem them.

What are the different types of savings bonds?

The two primary types of savings bonds are "I bonds" and "Series EE" savings bonds. Both accrue interest monthly at a variable rate and the interest is compounded every 6 months. All earnings are paid when you redeem the bonds.

"I" bonds are the newest savings bonds, first issued in September 1998, and are intended to offer protection against inflation. They are purchased at face value. The interest rate is made up of two parts: a fixed rate and a variable rate. The fixed rate will stay the same for the life of the bond. The variable rate is tied to inflation as measured by the Consumer Price Index and reset every 6 months. Because of the variable component, your overall rate will change every 6 months. If inflation goes up, the combination of those two rates will go up. If inflation goes down, the combined rate will go down. "I" bonds mature 30 years after the issue date.

Series EE savings bonds are issued at half their face value and stop earning interest 30 years after purchase. The rate reflects 90 percent of 5-year Treasury yields and is also reset every 6 months.

The HH bond is a current-income bond. The interest does not accrue, but rather, these bonds pay out the interest every 6 months. You receive the face value of HH bonds when you redeem them. An HH bond will stop earning interest 20 years after purchase. In the past, the only way to obtain an HH bond was to exchange a Series EE savings bond for an HH bond. But as of September 2004, investors are no longer able to exchange Series EE savings bonds for HH bonds or reinvest HH bonds.

Which is a better investment—"I" bonds or Series EE savings bonds?

When choosing between the two, you must weigh whether you think inflation is going to go up more or whether you think interest rates are going to go up more.

If you believe inflation is going to rise, then the "I" bond would be a better choice because its interest rate is pegged to the inflation rate. If you believe interest rates in general, and therefore Treasury rates, are going to rise, then the Series EE savings bond would make more sense because its rate reflects Treasury yields.

When can I redeem my savings bonds?

You can redeem your savings bonds after an initial holding period of 12 months. But you must pay an early redemption penalty equal to the last 3 months of earned interest if you redeem bonds sooner than 5 years after the issue date.

Is there any advantage to using savings bonds to pay for college?

Yes. The earnings from your "I" bonds and Series EE savings bonds may qualify for exclusion from federal income taxes if you use those earnings to pay for qualified higher education expenses in the same year you redeem your savings bonds.

Qualified expenses include tuition and fees for you or your dependents at colleges, universities and qualified technical schools that receive federal tuition assistance. Your income in the year you redeem the bonds must also be below certain limits.