Is Your Money Better Off Under Your Mattress?

Investing
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By Brian Frederick

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Ever since interest rates fell off a cliff around Thanksgiving 2008 as the Federal Reserve cut rates to stimulate the economy, I’ve been asked the question: “What’s the purpose of putting my money in the bank?” My response is that traditional bank savings accounts make sense for some of your goals, but not all.

It depends on why you want to save money and what your objective is. If you’re putting money aside for emergencies, you want it to be safe, secure and accessible when you need it. Any interest earned is just an added bonus.

If your bank account is earmarked to pay educational expenses that are more than five years away, low interest rates mean diminished purchasing power when it comes time to pay that tuition bill. According to the College Savings Bank, over the last five years the cost of college has gone up between 3.83%-4.36% per year for a total increase of 23%! During the same time, you’d have been lucky to make 1% per year in a savings account.

Depending on how much you have in the bank, the time frame you’re working with, and what your goals are, low interest rates can start having a material impact on your financial health before long. The question then becomes: What should you do with your precious savings to make your money work for you?

5 Ways to Enhance Your Savings

  1. Increase your yield with CDs. Certificates of Deposit, often referred to as CDs are FDIC-insured savings vehicles that give you a higher interest rate in return for having your money locked in for a certain period. Six months to five years are the most frequent periods, but I’ve seen CDs as short as 30 days and as long as 10 years. The longer you commit your money for, the higher the interest you receive as well as the more substantial the penalty for early withdrawal. Typically there is a sweet spot for rates in terms of getting more interest versus not having your money tied up too long, but you’ll need to look at your bank’s rate table. Use NerdWallet’s CD rates search tool to find the best CD rates in your area.
  1. Look into bond mutual funds. The most important thing to understand about bond funds is that while the current yield is higher than bank accounts, that higher rate doesn’t come without risk. Bond funds are not FDIC-insured and you will see the value of your principal fluctuate as interest rates move up and down. Bond prices and interest rates are inversely related, so if interest rates go up the value of your bonds goes down. Also, if an individual bond in a mutual fund’s portfolio stops paying interest or becomes more of a credit risk, the price of that bond will go down as well. Depending on how much risk you want to take, right now Vanguard has bond funds yielding between .31% and 4.63% (as of 4/23/2014).
  1. Check out money markets. At the risk of getting too technical, it’s important to note that money markets come in two flavors. Money market accounts are FDIC-insured bank products and money market funds are non-FDIC insured mutual fund investment products. Interest rates are also set differently between the two. Money market funds are required to pass through their investment earnings minus expense ratios to their shareholders. Money market accounts, on the other hand, carry whatever interest rate the bank declares. Historically, money market funds have had higher interest rates but in this low interest rate environment money market accounts have been yielding more and will probably continue to yield more as long as short-term interest rates are lower than 1%. Money market accounts have higher interest rates than savings accounts but frequently have a $10,000 minimum balance, as well as penalties for slipping below that minimum balance. They also limit withdrawals to between three and six per month. Money market funds come in four varieties:  taxable money markets (income is generally subject to federal and state taxes); tax-free money markets (generally the investment is in high-quality, short-term municipal securities that are exempt from federal income taxes); single-state municipal money markets (the same as national municipal, usually exempt from federal income tax and possibly state income tax, depending on your state of residence); and Treasury money markets (invested solely in Treasury bills which lowers risk).
  1. Consider U. S. savings bonds. Savings bonds now come in two flavors: I bonds and EE bonds. I bonds pay a fixed rate plus a semi-annual inflation rate. Currently, I bonds are paying a .20% fixed rate plus an inflation rate of 1.18% for a total interest rate of 1.38%. EE bonds currently have a nominal interest rate of .10% but if you hold an EE bond for 20 years, the bond will double in value, giving it an interest rate of 3.6% per year. Savings bond interest rates change every year on May 1 and November 1, so keep an eye on rates. You’re also limited in how much you can put into savings bonds. Right now you’re limited to $10,000 in EE bonds, $10,000 in I bonds, and $5,000 in I bonds purchased with a tax refund. These limits are per person, per year. The authoritative site for all-things savings bonds is www.TreasuryDirect.gov.
  1. Mull over Zero-Coupon Treasury Bonds (sometimes called Strips or Zeroes) inside of IRA accounts. Unlike bond funds, which pay interest monthly, or individual bonds that pay interest every six months, Zero-Coupon bonds are bought at a discount and then pay out their face amount at maturity. For instance, right now I can buy for around $19,000 a Zero-Coupon bond with a face amount of $25,000 that matures in May 2024 — reflecting a 2.82% interest rate to maturity.  The value of that $19,000 bond will fluctuate in the next 10 years, but as long as the U.S. Government is still in business in 2024, I’ll receive $25,000. One thing to be aware of with Zero-Coupon bonds is that even though you don’t receive interest until the bond matures, the IRS still ‘imputes’ that you earn interest every year that you’ll need to pay taxes on. As a consequence of this, I only recommend to purchase Zero-Coupon bonds inside of tax-sheltered retirement account such as an IRA, Roth IRA or 401k.

What have you found to be the best way to grow your money for the future? Do you have any currency under your mattress?