Dear Dollar Stretcher,
My husband and I currently have $11,500 in a savings account
in a credit union earning 1% interest with no minimum balance
restrictions. Our income was unsteady so we liked the flexibility
of this account. We have stable income now and are looking
at the money market account program. The bank thinks we should
switch as it would earn us 1.25% with a minimum balance of
$1,000. To me, these rates seem a bit low, however, we are
not ready to invest in the stock market. I have heard that
regular banks offer more interest but demand higher minimum
balances and have more restrictions etc. Are we better off
with the 1.25% money market account at our credit union or
should we move the money to a higher interest paying institution?
Sue
Sue is right that rates are low now. And that
makes it harder for savers to get much of a return on their
savings.
There are two characteristics that Sue will
need to evaluate on any investment. The first is liquidity.
Liquidity is the term used by investment professionals to
measure how quickly you can get your money. A dollar bill
in your wallet is very liquid. A money market fund is less
liquid, but still easy. Any 'timed deposit' with a maturity
date is less liquid.
The second characteristic is risk. Does an investment
put Sue's principal at risk? And, if so, what types of circumstances
would have to occur for money to be lost?
Be careful with the term guaranteed. All guarantees
are not created equal. In a insured savings account you're
guaranteed that you can go in any time and get $1 for every
$1 deposited. Even if the bank fails, there would be FDIC
or FSLIC insurance to get your money.
But other investments only guarantee your principal
at a maturity date. For instance, if you bought a 10-year
U.S. Treasury Bond you would be guaranteed to get your money
back when the bond matures. But if you needed the money before
then you'd have to sell it. And that could mean getting more
or less than your original principal amount.
Let's look at Sue's current options. How much
extra would she be getting by switching? Earning an extra
1/4 of 1% interest on $11,500 for a year is $28.75 before
taxes. Clearly you wouldn't take too many chances with $11,000
to gain $28 in extra income. Sue will want to find out if
there are any additional risks to her principal.
There are actually a variety of money market
funds. Some guarantee your principal. Others do not. Since
their inception, even non-guaranteed money funds have been
considered extremely safe. And the risk to principal has been
almost non-existent. But, with lower interest rates, some
money funds are finding that the interest earned doesn't cover
the expenses of managing the fund. When that occurs the money
market fund shares could actually shrink in value.
Sue mentions going to a bank. Certificates of
deposit (CD) could be a good alternative.
Right now a 5-year CD from the bank will pay
about 3%. The CD should be just as secure as the bank deposit.
You can get $1 for every $1 deposited at any time. You do
run the risk of losing six months of interest if you take
the principal before the maturity date. So it's possible to
lose $172.50 of earnings if you want to pull your money out
early. But the 2% higher interest will earn an extra $1,150
over 5 years if Sue manages to leave it in.
It's important for Sue to consider what she
wants this money to do. If it's to provide for funds for the
next auto breakdown or home repair, they'll need to be able
to get their money out any time. But if it's meant for only
a serious unexpected emergency, then she doesn't need the
same degree of liquidity.
One solution would be to keep part of the fund
for the next home emergency and the rest could be committed
for a little longer period of time.
Finally, there are other options that Sue could
consider. We can't go into the relative merits of each. But
if she looks at the potential return and the potential risks
she'll have a framework to evaluate the choices.
