The primary reasons for saving are to: (a) accumulate funds for meeting emer- gencies, (b) have funds available for purchasing consumer items, and (c) increase net worth, which is often referred to as capital formation. Savings strategies designed to achieve the first two objectives are significantly different from those associated with capital formation. This is because the major emphasis for saving for the first two reasons is on popular liquid assets. But the main criterion for capital formation savings is long-term growth. Here, the more traditional long-term investment vehicles are used.
There are six major criteria for determining where money should be saved:
safety, liquidity, return on savings, simplicity and minimum balance require- ments, special service features, and tax considerations. These criteria are dis- cussed further.
Safety
Today all national banks and many state banks are members of the FDIC. In addition, credit unions are insured by the NCUSIF for up to $250,000. This means
that the checking, savings, up to $250,000 for each account holder is protected.
Similarly, savings and loan associations are insured for the same amount by the Savings Association Insurance Fund (SAIF), administered by the FDIC. By using various combinations of accounts (individual, joint, trust, revocable, and so on) in banks, credit unions and savings and loan associations, a typical family of four can insure more than a million of personal savings. Besides the deposits insured by various government agencies, savings put into various types of government bonds are safe. However, money-market accounts at various brokerages and other financial institutions are neither insured nor completely safe.
Safety concerns were foremost on the minds of the American public when in 1988 widespread savings and loans association and bank failures were reported.
A similar situation arose during the financial crisis of 2008. The Bush and Obama Administrations quickly moved to bail out the failing institutions, ensuring that no one lost their savings. However, the “financial crisis mess” created deep con- cerns among the public. Fortunately, confidence in savings institutions appeared to have been restored.
Liquidity
If one desires to convert savings into cash quickly without losing the principal, checking and savings accounts in banks and credit unions as well as money- market accounts provide a high degree of liquidity. In contrast, CDs provide higher interest rates but restrict withdrawal privileges. Similarly, various types of the US govern- ment bonds lack complete liquidity. An early withdrawal may result in a partial loss of return.
Return on Savings
An important criterion in selecting a savings institution is the return it offers.
Actually, the true return on savings depends not only on the advertised rate, but also on other considerations, including the type of account used for accumulat- ing savings. This point requires elaboration.
Bank Savings Accounts. The most traditional of all bank savings accounts, which were previously called passbook accounts, form the backbone of bank savings.
Until the interest rate ceiling was removed in April 1986, the maximum legally allowable rate on regular savings in federally insured institutions was 5.5 per- cent. Even with the legal ceiling removed, in the low interest environment fol- lowing the Great Recession, the interest rate paid on bank savings deposits has fallen to near zero percent.
Bank Checking Accounts. Contrary to commonly held belief, interest can be earned on checking accounts, but only if certain stated criteria are met.
Generally, a regular checking account pays no interest and usually costs about
$5.00 per month. This cost is generally waived by the bank if a minimum bal- ance of $1,500–$2,500 is maintained. In contrast, NOW (negotiated order of withdrawal) accounts pay interest and also allow check withdrawals. Often they waive maintenance fees if a minimum balance of $1,000 is maintained. Some internet based companies offer interest rate on FDIC-insured NOW accounts that are significantly more than others. Based on June 13, 2012, data, Table 6.7 presents the variation in rates offered and conditions imposed—the NOW account rate ranges from 0.90 to 1.00 percent. Another variety, popularly known as MMDAs (money-market deposit accounts) are not full-fledged checking accounts because they limit the depositors not only to three checks and three preauthorized transfers per month, but also require a minimum balance of
$300–$500. However, these accounts pay the highest rates of any bank account on which checks can be written.
For those with $5,000–$20,000 in cash and securities, AIOAs (all-in-one accounts) provide the best alternative. These accounts consist of a package of automated cash management, preferential personal treatment, and certain investment ser- vices provided by the bank or an outside firm that offers such services for the bank.
On the cash management side, the bank covers the check written by the deposi- tor by transferring exactly the right amount from the money-market balance to the checking account. On the investment side, the depositor can use the bank facilities not only for trading securities but also for financial planning, managing real estate investments, and trust and estate planning. Even more important, divi- dends, interest, and proceeds from the sale of securities are deposited directly into the interest-bearing money-market account.
The Real Yield. One of the most difficult tasks savers face is to figure out the real yield on their savings. The reason is obvious. Fierce competition for available savings often prompts financial institutions to make exaggerated claims that must be decoded to identify the real yields.
Simple versus Compound interest. A common practice among financial institu- tions is to advertise a high interest rate on multiyear accounts; but it is only simple interest, and not compound interest. This practice can be utterly mis- leading to the neophyte and the unsuspecting saver. For instance, if ABC bank pays 5.75 percent simple interest on its five-year CD, and XYZ bank pays only 5 percent interest on its CD compounded annually over the same period, to the
Table 6.7 Examples of Interest Rates Offered on Checking Accounts
Institution APY Min.
Dep. Min. To
Earn APY Details
ING Direct 0.90% $100,000 $100,000 Electric Orange Checking—Tier $100,000 and up
Incredible Bank 0.88% $1,000 $0 None
ING Direct 0.85% $50,000 $50,000 Electric Orange Checking—Tier $50,000–
$99,999
Chesapeake Bank 0.80% $25,000 $25,000 Clear Sky Checking—Tier $25,000–$249,999 Ally Bank 0.75% $0 $15,000 Rate is for balances of $15,000 or more—
Apply online
Ally Bank 0.40% $0 $0 Rate is for balances less than $15,000—
Apply online Commonwealth
Community Bank 0.20% $1,000 $0 NOW Checking—$10 monthly fee if balance falls below $1,000 during cycle Viking Savings Bank 0.20% $100 $250 Interest Bearing Checking
ING Direct 0.20% $1 $0 Electric Orange Checking—Tier $0–$49,999
—Online account—No fees, no required balance—Requires direct deposit First State Bank of
Wyoming 0.10% $0 $500 Advantage Plus Checking—$10 monthly fee and $0.25 per debit charge if average balance falls below $500
Citizens Bank
(Rate in PA) 0.05% $250 $1 Circle Gold Checking with Interest—$20 monthly fee waived with $20,000 balance in linked accounts. Requires relationship package—Rate collected within: 19140 (PA) Chase (Rate in CA) 0.01% $25 $0 Chase Premier Checking Tier $0–$9,999—
$20 monthly fee waived with combined average daily balance of $15,000 in linked deposit, loan and investment accounts—$2 for each non-Chase ATM withdrawal, balance inquiry or transfer—
Rate collected within: 94115 (CA) HSBC Advance 0.01% $1 $5 HSBC Premier Checking—Online only
HSBC 0.01% $0 $5 Plus Checking—Stated rate is for accounts
opened at an HSBC branch or by phone Chicago Community
Bank 0.00% $0 $0 High Interest Checking
Credit Union 0.12% $0 $2,000 $5 service fee for balances less than
$2,000, unlimited check writing, free bill payment, APY is tiered based on balance.
Source: Author’s own work.
uninitiated the former bank looks more attractive. But based on what we learned in Chapter 3, in reality it is the XYZ bank which offers a better deal.
Delayed Deposit Credit. The real yield on a deposit also depends on the number of days the money is allowed to earn interest. Some banks wait several days before crediting the account with the new deposit. This practice could signifi- cantly cut the yield on the deposit.
Minimum Monthly Balance Requirement. Basically, there are six methods for paying interest: (a) low quarterly balance, (b) low monthly balance, (c) pro rata balance—FIFO, (d) pro rata balance, LIFO, (e) day-of-deposit to day-of- withdrawal balance, and (f) average daily balance. For instance, assume a $10,000 deposit is made on January 1 at 5.25 percent, and no additional deposits or withdrawals are made for a year. If interest is compounded and paid quarterly, under each of the preceding six methods the annual interest would be $535.42. Differences among these methods result from deposits or withdrawals of funds during the interest period and their effect on the final amount of interest paid, depending on which method of calculation is used.
The best savings method for depositors is the average daily balance method, in which the bank calculates the ending balance for each day, and then computes the average balance for the period to get the amount for which it is paying inter- est. The worst is the low balance method, in which the bank pays interest each day based on the lowest daily balance on deposit.
Grace Period Allowance. Grace days are also important in determining how much interest an account will earn. A grace period for deposits allows savings institu- tions to pay the interest from the first calendar day of the month and also on deposits withdrawn during the month’s last three business days (called dead days). When a bank allows a grace period, it automatically boosts the real yield.
Other Factors. Other factors that affect real yield include charges for excess withdrawals, penalties for premature closing of accounts, and other assorted charges. The impact of these charges and penalties on the real yield can vary greatly depending upon individual policies adopted by various financial institutions.
Money-market Mutual Funds. A money-market fund is a mutual fund that invests only in short-term money-market instruments. Investors purchase and redeem these shares without paying a sales charge. Minimum initial investments for most funds vary from $500 to $5,000. Generally, these funds have a check
writing option that enables individuals to write checks of $300 or more. Shares can also be redeemed from most money-market funds by telephone or wire request, in which case the fund either mails the payment to the investor or remits it by wire to the investor’s bank account.
Money-market mutual fund rates are generally higher than those offered by banks on savings accounts. However, unlike bank accounts, money-market mutual fund accounts are not FDIC insured. Interest earned varies, depending on the type of short-term securities held by the fund. Those holding three- month Treasury bills will yield far less than those holding lower grade com- mercial papers. The best rates should be in the vicinity of short-term interest rates
Certificates of Deposit. CDs significantly differ from savings accounts: They must remain on deposit for a specified period. Investors earn a higher return on CDs than on savings. The difference in the rates depends on a CD’s amount and the length of maturity. However, a substantial interest penalty is imposed on early withdrawal from a CD. And it may result in partial loss of the principal.
Mention may be made here of brokered CDs that have gained popularity in recent years. Brokered CDs are simply CDs issued by a bank or a savings and loan association through a middleman—a broker—who gets paid a commis- sion by the issuing institution. As long as the issuing bank is covered by the FDIC, brokered CDs are insured by the FDIC up to the usual $250,000 limit.
The incentive for investing in a brokered CD does not come from a superior return, for generally the returns on these CDs are not appreciably higher than those on ordinary CDs. Their main attraction is that investors can liquidate them at any time without incurring the usual early withdrawal penalty associated with ordinary CDs.
Treasury Bills. The US Treasury bills are the shortest-term marketable US obliga- tions offered and, by law, cannot exceed one year to maturity. The most fre- quent and most popular Treasury bill issues are three-month and six-month maturities which are offered on a weekly basis. Bids (tenders) for both issues are usually invited approximately one week prior to the auction. At that time, the amount offered and the terms of the offering are announced, with the terms for the two issues being similar. Treasury bills are sold on a discount basis. This means that investors pay a discount price for a bill but receive the face value upon maturity. The difference between the discount and maturity prices, or the additional cash received, as a ratio of that investment is the return on the Treasury bill. The minimum denomination of a Treasury bill is $10,000, followed
by increments of $1,000. Although Treasury bills are liquid and safe, an investor selling them before maturity could incur a loss.