If you follow my blogs, you will have gone through an exercise to set both short-term and long-term financial goals. (See my blogs: Set Your Investment GPS, The Battle of Needs vs Wants, and Choices.) Saving is what is meant when you set aside funds for short-term goals, those goals with timeframes shorter than 5-7 years. This blog will cover where to go to find saving vehicles, what products are appropriate, and their safety.
Places to Save
Commercial banks, credit unions, and thrift institutions are places to find vehicles for saving. Which should you choose and what are the differences? The main difference between a commercial bank or thrift and a credit union is that a banks and thrifts are for-profit financial institutions, while a credit union is a cooperative and usually nonprofit.
Commercial banks may be owned privately, by a family, for instance, or may be owned by shareholders (investors) and have stock that is publicly traded. Banks focus on providing a return or profit to the owners or shareholders. They will typically have many locations for customer convenience and offer a wide variety of products and services. Some banks do not have brick-and-mortar locations but operate with an online presence. You would expect online banks to have lower expenses because they do not have physical branch locations to support along with their associated staff and other costs. The savings might mean greater profit to the owners and/or better deals for customers, or a combination.
Credit unions are owned by the people who use their services—their depositors or members— and return profits to their members in a couple of ways. Credit unions might pay a higher rate of interest (percentage you will earn) than a bank for money you deposit with them. Credit unions might charge a lower rate of interest (your cost to borrow money) for a loan than those charged by banks. The total interest paid to you on a deposit or that you pay for a loan depends on the principal (the dollar amount of the deposit or loan), the interest rate, the interest payment frequency (how often interest is paid or due: monthly, quarterly, or annually, for example), and the length of time over which the money is deposited or borrowed.
Thrift institutions are savings and loans and mutual savings banks. They can be organized like a bank (owned by investor shareholders) or a credit union (owned by the depositors), but they are always for-profit. Thrifts offer many of the same products as banks, but traditionally, they emphasize consumer lending more than commercial or business lending.
When you place your money in a bank or credit union for saving, you open an account. Ownership of an account is described in its title. The owners may be an individual, a business, or two or more people together. They can even be a legal entity such as a trust or an estate. In addition to describing the owners, the account title may describe its purpose—for example, an Individual Retirement Account (IRA). The owner of an IRA is an individual, one person, and the money deposited in the account is intended to fund retirement.
When you open an account, you will go home with a receipt that describes your purchase and then receive periodic statements. Statements are typically issued monthly or quarterly. You might be able to access your account information online as well. Online, the updates might be more frequent.
How do you know your accounts are safe? Most saving accounts are covered by some type of insurance protection in case the bank, credit union, or thrift becomes insolvent—the unlikely event that they are not able to return assets to owners. The amount of insurance protection is related to the type of entity and to the owner of the account.
The Federal Deposit Insurance Corporation (FDIC) insures deposits at commercial banks and thrift institutions. Insurance is offered according to the ownership category and how the accounts are titled. The standard deposit insurance coverage limit is $250,000 per depositor, per FDIC-insured bank, per ownership category. If you are a single person and have a checking account, a savings account, and a certificate of deposit at your favorite bank with a combined value of $300,000, only $250,000 will be covered by insurance. All of it would be covered by FDIC insurance if you moved $100,000 to a different bank or thrift.
Credit unions are covered by a different type of insurance — National Credit Union Share Insurance Fund (NCUSIF). The coverage is like that of the FDIC, and coverage limits are the same.
Products for Saving
There is a type of account that is not a good fit for saving, and you need to remove it from consideration. Checking accounts hold money you can access easily via check or debit card. If you earn a wage or salary, your pay is probably deposited directly into a checking account at a bank or credit union. Even if it pays a low rate of interest on your balance, a checking account is not a good place for your savings. Why? It is too accessible. Saving requires patience, even though the funds are meant to cover short-term goals. The purpose of a checking account is to pay for everyday transactions. Do not mix funds for saving with funds in your checking account. So then, what kinds of vehicles are good for saving?
If you have a short-term goal and you want your money to earn interest but do not want the risk that you will lose any of the amount that you save (the principal), a money market account, a savings account, or certificate of deposit are all appropriate. A money market account or savings account is also a good place to park your emergency funds, the money set aside for an unexpected need such as the loss of income due to the COVID-19 pandemic. (See my blog, Your First Financial Step.)
If you choose a money market account, you can expect to easily move money both in and out of the account with few restrictions. Some money market accounts even have check-writing privileges or a debit card, but if you are using this product for saving, you must resist the temptation to use those features until you reach your saving goal. The rate of interest—what the saving institution pays you for the use of your money—will change from time to time. The interest will be added to your account balance periodically, usually monthly.
A savings account may pay a higher rate of interest than a money market account, and the rate will change less frequently; however, a savings account typically has more restrictions. The number of times you can take money out of the account each year may be limited, for example, and savings accounts have no checks, but they may have an ATM access card. Again, the interest you earn will be added to the account regularly. Compare the rates of interest and any restrictions before choosing between a money market and a savings account. If the information is not readily available, ask.
You may also want to consider a certificate of deposit (CD) for saving. A CD is a type of deposit locked in for a specific time, from months to several years, usually with a fixed rate of interest. The interest you earn on a CD should be higher than either a money market account or a savings account because your money will not be accessible until the date the CD matures. The maturity of the CD is set at purchase; therefore, CDs are good places to put funds if the money will be needed on a specific date.
For example, imagine that your grandmother gave you $1,000 for your birthday, and you intend to use it for a vacation trip in one year. You want to put the gift in a safe place where you will not be tempted to use it for anything else, so you decide to purchase a $1,000 face value CD for one year. The best rate of interest that you find for a one-year CD is 1.50%. At maturity, you will receive $1,015: the principal or face value, $1,000, plus the interest earned, $15. Some CDs pay interest more frequently, so be sure to ask.
Remember, money market accounts, savings accounts, and CDs are usually covered by insurance —FDIC or NCUSIF. Some savings institutions post their CD rates online to attract a wider group of buyers. If you choose to go that route, confirm the insurance coverage, and make sure you understand any fees or restrictions. Also, if you buy a CD at a premium (pay a price over its face value), the premium portion will not be covered by insurance.
Even though I do not recommend combining money set aside for saving and money set aside for investing, you may be able to earn a higher rate of interest on a CD purchased through a brokerage account. There are important differences if you do, however.
First, broker-dealers do not issue CDs; they sell CDs issued by savings institutions. Insurance coverage is provided by the CD issuer— the bank or thrift institution. For insurance coverage, it does not matter if you buy the CD directly from the bank or if you buy the CD through a broker-dealer. The ownership rules for insurance coverage still apply. If you purchase a CD through a broker, the broker may charge you a transaction or other type of fee. Why? Since brokerage firms do not issue CDs but instead sell CDs issued by banks and thrift institution, a transaction fee or handling fee is how the broker-dealer covers its costs.
“Breaking” a CD
What happens if you need your CD money before maturity? There is another difference between CDs purchased through a broker-dealer and those purchased directly from a bank, and that comes into play if you need your money prior to the maturity of the CD.
If the CD was purchased through a broker-dealer, the CD will likely be “put out for bid” in the market. The bidding process works kind of like a silent auction. Bidders will offer a specific dollar amount for your CD, and you may receive less than the CD’s face value (also called par value), your principal purchase amount. You will, however, receive the full amount of interest that you earned up until the date of the sale. Again, the broker-dealer may charge transaction fees or other fees on the sale.
If you purchased your CD directly from a bank, the bank will redeem it at face value, but you may incur an early withdrawal penalty, which can be substantial. In either case, you will likely be penalized if you need your money before the maturity of the CD, so try to match the maturity with the point in time you need the money.
If you are somewhat unsure of the date you will need the money, you might consider a CD ladder. Just as a ladder has several rungs, a CD ladder has several maturities. You might put part of the money meant for your wedding, whose date is set a year from now, in a CD that matures in one year, part in a CD that matures in six months, part in a CD that matures in two months, and the rest in a money market account. As wedding expenses arise—the bridal gown, venue, flowers, cake, etc.—the money is safe, is earning interest, and will be available when you need it.
It is important to fully understand saving vehicles and their associated costs, fees, or penalties. If the information is not readily available, ask. Then, take advantage of correct ownership titling to safeguard your money and assure full insurance coverage. If you have a very large amount of money for short-term goals, over the limit of insurance coverage, it is a good idea to spread your funds among multiple banks, credit unions, or thrift institutions. Doing this will make sure you have full insurance coverage in the event of an insolvency of one of them. You want your savings to be safe!
~Bev Bowers, CFP®