How Do You Earn Higher Rates on a Savings Account?

“The return OF capital is more important than the return ON capital.” – Old Investing Proverb

A reader asks:

I’m getting sick and tired of earning such low interest rates on my savings account. Should I invest in stocks or bonds to get a better return on this money? What are my alternatives if rates continue to stay low for the foreseeable future?

Throughout the 1990s you could put your money in a regular savings account at a bank and make anywhere from 4 – 5% in interest on that money. CDs and intermediate term bonds were offering rates even better than that, even as late as 2005 or 2006.

In fact, the Federal Funds Rate, which banks base their savings account interest rates on was 5.25% at the end of 2006. Sounds pretty good right about now, doesn’t it?

Because of the lingering effects of the financial crisis central bankers around the world have kept interest rates extremely low to try to boost economic activity. Interest rates on savings accounts are basically non-existent these days.

The best rates are offered at credit unions or online banks. Capital One 360 (formerly ING Direct) offers around 0.75% right now for an online savings account. Ally Bank offers 0.84% at the moment (these rates are variable so they could change). Certificates of Deposit and short-term bond rates aren’t much better or even lower in some cases.

The Fed and other central bankers around the globe are trying to get investors to go out further on the risk curve (stocks, junk bonds, mortgage bonds, etc.) with their capital. This has made it very difficult for income-seeking investors and those looking for a safe vehicle (meaning principal loss protection) to park their short to intermediate term cash.

FOCUS ON YOUR TIME HORIZON
This question brings me to one of the biggest factors investors need to think about when choosing an investment – time horizon. The length of your investment holding period and when you need the funds for spending purposes should be a large determinant of your risk tolerance.

Obviously, everyone will have different circumstances. You don’t want to take increased amounts of risk for short-term goals. The randomness of losses in the stock and bond markets is too hard to predict.

As you get closer to realizing your goal (actually spending the money), you should be moving your funds into more risk averse investments.

Most people use their savings accounts for things a house down payment, car down payment, vacation fund and other 1-5 year savings goals.

WHAT ARE YOUR OPTIONS?
You first need to look at the alternatives before you decide what to do with your savings. Here are the basic options:

1. Invest in stocks though an index ETF: This is a tax efficient option because index ETFs have a low amount of taxable sales and distributions. But as Warren Buffett once said, “You shouldn’t invest in stocks unless you are willing to lose 50% of your money.”  This is not too far out of the realm of possibility considering this has happened twice to the stock market since the year 2000. You could make more money going this route but the possibility of loss is far too risky with funds that you will need in the short-term. Stocks probably should not be used for any time horizon under five years to be safe.

2. Invest in short to intermediate term bond funds: This is a way to reach for a little more yield than savings accounts because the terms of the bonds are a little longer in duration. The general the rule for bonds is the longer the duration the higher the yield and vice versa. So 30 year bonds generally have higher yields than 5 year bonds, all else equal. You do have to pay taxes on the interest (same with a savings account, but those are easier to track) and also on the sales that you make if you have any capital gains.

But the real risk for bonds is that they do go down in price if interest rates rise so you can actually lose money. This is a foreign concept to anyone investing in bonds in the last 30 years or so because interest rates have been on a steady decline since the early 1980’s. It’s probably safe to use bonds for time horizons of over 3 years but make sure you stay on the very low end of the maturity spectrum (1 to 2 years).

3. Invest in money market funds or CDs: This is probably the best option to increase yield over a savings account, but not by much. Most of the account minimums are fairly high ($10,000 or so) for money markets to get rates that make it worth it to invest in these instruments. Five year CDs average 0.51% right now, so CDs mkae no sense since you lose flexibility and ease of access.

Credit Unions may offer interest bearing checking and savings accounts with more competitive rates than CDs or money markets so that is not a bad option either.

4. Online savings accounts: Keeping your money in the an online savings account and being able to sleep safely at night knowing your money is protected from sinking markets and the loss of principal is probably your best bet. The rates are better than at a brick and mortar bank savings account and you have the flexibility of withdrawing the money without having to make an actual sale (it’s a simple transfer of funds to your checking account).

Option 4 is the one that would I go with almost every time because it is the safest and easiest route. You don’t want to be messing around with the stock or bond markets with your house down payment (or similar goal) because you never know when you will find the home of your dreams.

You have to realize that cash and cash equivalents (savings, CDs, money markets) are an asset and not an investment.  Your cash needs to be highly liquid in nature and easily accessible.

While it would be nice to earn 3-5% on that money when you park it for a couple years, you are much better off keeping it in an FDIC insured savings account, even with next to nothing yields. Higher returns come from higher risk and reaching for yield can lead to more risk than you may realize.

Remember that every 1% increase in rates on $10,000 of savings works out to $100 a year or $8.33 a month. It’s not worth the risk to reach for yield for such a low payoff.

So the next time you’re thinking about moving out of your savings account to make a few extra bucks each month just remember how your risk profile and time horizon must be aligned with your goal for how you plan on spending that money.

What can you do to take advantage of the low interest rates?
Refinance your mortgage. These low rates will probably look laughable in 10-20 years. Take advantage by refinancing to a fixed rate 15 or 30 year mortgage. If inflation ever picks up you will basically be paying even money for your mortgage payment every month.