Comparing Types of Savings Plans – Textbook Personal Finance

This post is part of the textbook personal finance series which covers basic personal finance skills by going through an actual textbook, chapter by chapter. Check out the intro post for more information.

Last week, we looked over comparing types of financial institutions. Today I’m going to goo through the section on comparing savings plans.

No one savings plan is superior to all the others, since each has their place. The table below illustrates the benefits and drawbacks of each type of account. Click on the type of account to visit the section below and see a fuller description of the account.

Comparing Savings Plans

Type of Account	Benefits	Drawbacks
Regular savings accounts	Low minimum balance Ease of withdrawal Insured	Low rate of return
Certificates of deposit (CDs)	Guaranteed rate of return for time of CD Insured	Possible penalty for early withdrawal Minimum deposit
Interest-earning checking accounts	Checking privileges Interest earned Insures	Service charge for going below minimum balance Cost of printing checks; other fees
Money market accounts	Favorable rate of return Allows some check writing Insured	Higher minimum balance than regular savings accounts No interest or service charge if below a certain balance
Money market funds	Favorable rate of return Some check writing	Minimum balance Not insured
U.S. Savings bonds	Fairly good rate of return Low minimum deposit Government guaranteed Exempt from state and local income taxes	Lower rate when redeemed before five years

Evaluating Savings Plans

Rate of Return

The earnings on savings can be measured by the yield (often called APY—Annual Percentage Yield) or interest earned on the account. The rate of return is determined by dividing the interest by the amount initally in the savings account.

Every time interest is added to the account, it’s called compounding and an account that compounds often will yield a higher APY than an account that only compounds rarely.

The Truth in Savings Act requires your financial institution to disclose the fees on deposit accounts, the interest rate, the APY, and other terms an conditions.

Inflation

The reason that you need to earn interest on your money rather than just sack it away is that your money will be worth less 5 years from now than it is now (normally). Consider inflation when choosing a type of account in order to beat inflation (i.e. you probably shouldn’t put everything in an account that earns no interest).

Taxes

In most cases, you’ll have to pay taxes on interest earned. Be sure to factor this into your decisions.

Liquidity

Liquidity is the ability ot withdraw your money on short notice without fees or loss of value. This is why you may not want to keep all of your money in something like a CD or bond which loses value if you withdraw before it’s matured. On the other hand, if you have adequate savings in an accessible account, then you may benefit from having money in these other accounts without as much risk.

Safety

These accounts are insured (or not) by the FDIC as noted. So far, the FDIC has been able to cover money in banks which have failed during the recession.

Types of Savings Plans

Regular Savings Accounts

Savings accounts usually earn a low rate of interest. They are insured by the FDIC and available for immediate withdrawal. There is normally a limit on the number of withdrawals you can make during a single month.

Certificates of Deposit

Certificates of deposit guarantee a rate of return when savers leave the money with the bank for an extended period of time. They are FDIC insured. The only drawback is that you’re locked into a particular interest rate and there is often a penalty for withdrawing the money early. There is also usually a minimum.

Some people manage CDs by using a CD ladders. This allows them to spread out interest rates, locking some in for long periods and have others mature earlier so that they could potentially be rulled into new CDs which may have higher interest rates.

Interest-Earning Checking Accounts

There are many checking accounts available which also earn some interest. Generally these don’t earn as much as savings accounts because of their flexibility. They may also have a minimum required deposit. They are FDIC insured.

Money Market Accounts

Money market accounts are essentially savings accounts with varying interest rates. The interest rates fluctuate according to the market. They almost always have minimums, like CDs, but they allow for a limited amount of check-writing, like withdrawals from savings accounts.

Money Market Funds

Money market funds are very similar to money market accounts, but money market funds are not FDIC insured. They tend to invest in safer vehicles, so they’re not as volatile as mutual funds that invest in stocks.

U.S. Savings Bonds

U.S. Savings bonds earn interest based on the amount of time they’ve been held, anywhere from 5-30 years. Interest earned on them may be exempt from federal taxes under certain circumstances (such as paying for tuition) and are exempt from local taxes. You also don’t have to pay any taxes on the interest until you redeem the bond.