Like many parents, my wife and I made our children set up savings accounts at our bank. Each month, when the bank statement came, I would show them how the bank had paid them interest. “Look at this,” I would say, “The bank just paid you $1.03 just for letting them hold your money last month!” Since that was during the “pre-allowance” era, they thought it was pretty cool that they got paid a buck for doing, quite literally, nothing.
Last month, I considered reviewing the bank accounts with kids. But I did not have much to go on, as they had each earned just one cent in interest. As you might imagine, it is hard to excite a teenager about a penny. Since stocks are still a see-saw proposition, and they are never a “sure thing,” that leaves many people wondering where they can put their money and still earn a respectable amount of interest.
Interest Rate Collapse
First, let’s examine why savings accounts pay such dismal interest. For the most part, banks earn money by making loans, with mortgage loans and car loans being two of the biggest types of loans. Interest rates on mortgages are less than 5%; new car loans have rates less than 6%. These rates are so low because the Federal Reserve has set very low target rates for interbank loans and federal debt in order to stimulate the economy.
Such low rates are great for people who borrow money; in fact, mortgage rates are near historical lows. However, because the federal interest rate targets are so low, the banks cannot charge much more for their standard loans. And since they get such low rates on what they lend, they have little left (after expenses) to pay as interest to the people who save.
A standard savings account at a mainstream bank has a current rate of about 0.02%. So if you put $100 into an account, you can expect to be about two cents richer at the end of the year. For all practical purposes, you are basically giving them the money for free.
Options for Safe Deposits
Banks do offer other savings options besides standard savings accounts. The normal savings account is desirable because it generally has a lower minimum balance and you can access your money very easily. For this flexibility, though, you are receiving almost no interest.
One step up is a money market account. These accounts can be covered by the Federal Deposit Insurance Corporation (FDIC), which is the government program that protects all deposits up to $250,000 at a given financial institution. Money market accounts are invested differently than normal savings accounts, generally have higher minimum balances, and may even have restrictions on how frequently you can access your money. In return for these restrictions, though, you can earn about 10 times more interest. Of course, this still puts you at 0.10%. At that interest rate, you will double your money in seven centuries.
Certificates of deposit, or CDs as they are commonly known, generate even more interest. A one-year CD has an interest rate of about 0.75%; a five-year CD has a rate of around 2.25%. The CD is clearly the best way to earn interest in a government-protected bank account. However, a CD has a distinct disadvantage: you cannot access the money during the term of the CD. If you sign up for a one-year CD, the bank gets to hold your money for a full year. If you need to get the money for an emergency, you will sacrifice all interest you may have earned, and you may even have to pay a penalty.
You can take advantage of CDs by “laddering” them. Laddering is taking a sum of money and buying CDs that overlap their renewal dates, so that you can withdraw the cash should you need it. Say you have $5,000. On the first of the month, you place $2,500 into a 30-day CD. On the 28th of the month, you place the other $2,500 into a 30-day CD. Then, every 15 days, you will have a $2,500 (plus interest) CD expiring. That way, if you need to replace a transmission in your spouse’s car, you will have money available. If there is no emergency, you can roll the CD over for another 30 days. You can continue the laddering, or roll-over, cycle as long as you don’t need money from either CD. By laddering, you can earn 10 to 15 times more interest with your money.
The Federal Reserves efforts to stimulate the economy have driven interest rates to rock bottom; that means that savings rates are also near rock bottom. Traditional banks offer a lot of security to savers, but they pay such minimal interest, it can be difficult to save. Banks do offer a number of options for saving, and by laddering your efforts, you can take advantage of higher rates and still have flexibility in accessing your money.
Admittedly, earning a quarter or half of a percent in interest is not very exciting…but it beats just getting a penny. Because with the standard savings account, a penny saved is still just a penny.
About The Author:
Jonathan Bastian is a police officer in Lexington, Kentucky. He is a noted author on thermal imaging technology, but has a passion for personal finance and helping people spend money wisely. He has a bachelor’s degree in business economics and international relations (commerce emphasis), and paid for several Spring Break trips by “buying low and selling high.” He is still a cop by trade, so his suggestions and comments are not intended as formal tax, financial or accounting advice. Consult paid professionals if you need formal guidance.