Investing 101: Bank Products
Last month, I started a series of posts about investing, to help build a foundation of knowledge for readers who are newer to the topic.
As I noted in my initial post, bank products are probably the most familiar type of investment to many readers, and include products provided by your local bank or credit union, such as savings accounts, checking accounts, money market accounts, and certificates of deposit.
We’ll start with a list of things to consider before investing in any bank product, and then go into more specific details about the primary types of investments you can get at a bank.
Some things to consider before investing in most bank products include:
1. What interest rate and annual percentage yield (APY) does the account pay?
The interest rate is the amount your account is credited, as a percentage of the total amount of money in your account. Say you have $1,000 to invest. You decide to put that money into a bank product paying an interest rate of 1% a year. After a year, you will receive $10 in interest ($1,000 times 1%), and your account will have a total value of $1,010.
The APY is the effective annual rate of return on your investment after taking into account compound interest. In the above example, where interest is credited just once a year, your interest rate would be exactly the same as your APY.
The interest rate on a bank product and the APY on a bank product will usually be similar, but not exactly the same, because most accounts will compound your interest (which we will explain shortly) more than once a year.
Normally, the higher the APY you receive, the better. Traditional brick and mortar banks typically offer lower interest rates than online banks, which don’t usually have the same type of overhead expenses.
2. How is the interest compounded?
In the example above, interest was compounded annually. In reality, with many bank products, your interest will be compounded more frequently. This is good for you as an investor, as the more frequently your interest is compounded, the more money you will eventually earn!
When interest is compounded, it means you are earning interest on not just your principal (the money you invested), but also the interest you have previously earned.
I’ll explain. Let’s once again assume you put $1,000 into a bank product paying an annual rate of 1%. But this time, the interest is compounded semi-annually (every six months), instead of once a year.
Six months after opening your account, you receive your first interest payment. That payment will be $5 ($1,000 times 1% times 0.5, since we’ve only earned interest for half of the year).
But now you have $1,005 in your account. So when you receive your next interest payment six months later, it will be $5.025 ($1,005 times 1% times 0.5), rather than $5.00. Your account balance at the end of the year will be $1,010.025 with semi-annual compounding, which is slightly larger than the $1,010.00 account balance we saw with annual compounding.
While this difference is very small (literally pennies!), when higher interest rates are combined with more frequent compounding over longer time periods, the impact can be material.
The following chart shows how $1,000 would grow over a period of 10 years at an interest rate of 10% with different types of compounding:
Keep in mind, the amount deposited, the quoted interest rate, and the time the money had to grow were all exactly the same. The only difference driving how much you would end up with is how frequently your interest was compounded.
Albert Einstein reportedly said that compound interest is the most powerful force in the universe. Whether you invest in bank products, bonds, stocks, mutual funds, real estate, or something else, if you invest early, and often, the power of compound interest can do amazing things for your portfolio over time.
3. Is a minimum balance required?
Some bank products require an initial deposit of a certain size to open up an account, and/or maintenance of a certain balance to avoid being charged fees. If you only have a small amount to invest, you might be better off with an account that offers a lower APY with a smaller minimum balance requirement than an account with a higher APY but a larger minimum balance requirement. If you fall below the minimum balance requirement, fees can add up quickly, eating up some – or all – of your potential interest income.
4. Are there any deposit or withdrawal restrictions?
Rules around deposits and withdrawals can vary significantly among the various types of bank products, and one bank can have different rules on its products than another one. It’s always a good idea to read the fine print to make sure the account you are opening meets your needs, and that you won’t incur any penalties if you are too active in your account or need your money back for some reason. As we’ll discuss later, certificates of deposit have some very specific withdrawal restrictions to consider.
5. What, if any, fees are charged?
As mentioned above, fees can be associated with not meeting minimum balance requirements or making too many transactions, but banks can also charge fees on bank products in many other circumstances. You should make sure you have a good understanding of any and all potential fees you could be charged before opening an account. In lower interest rate environments like today’s, fees can have a significant impact on your earning potential!
6. Is the product FDIC insured?
If you have ever been into a bank branch, you have probably heard of the Federal Deposit Insurance Corporation (FDIC). The FDIC was created during the Great Depression to help restore trust in the American banking system. Today, the FDIC insures deposits of up to $250,000 at member banks against bank failures. As of August 3, 2017, there were 5,786 FDIC-Insured institutions in the United States. To find out if your bank is FDIC-Insured, use this link.
While checking accounts, savings accounts, certificates of deposit, and money market accounts at member banks are typically covered by the FDIC, it’s always a good idea to double-check. Note that the FDIC only insures against bank failures, and not against fraud, theft, or any other types of losses. Also, keep in mind that other types of accounts and investments that banks often provide are not FDIC insured. This link will connect you to a page on the FDIC website that outlines what types of accounts are potentially covered, and not covered, by FDIC-Insured institutions.
If you have direct deposit of your paycheck into a bank account, your money is likely going into a checking account. You might also use a checking account for online bill paying or other electronic transfers, as well as – you guessed it – writing traditional paper checks! If you have an ATM/debit card, it is likely connected to your checking account. Checking accounts are designed for frequent transactions, so there may not be too many restrictions on your potential deposit and withdrawal activity, but it’s always wise to check the relevant terms and conditions.
In general, you aren’t going to earn much interest keeping your money in a checking account. Checking accounts often pay lower interest rates than other bank products, and in many situations, pay no interest at all. Consequently, you probably will not want to keep too much money in your checking account. That said, you should make sure to keep enough in your account to avoid overdraft fees, which you can incur if you don’t have sufficient funds in your account for a withdrawal.
You should also make sure you are aware of any monthly maintenance fees or minimum balance requirements associated with your checking account. Many banks offer “free” checking – but only if you maintain a certain minimum balance, and/or automatically deposit your paycheck into the account. Fees can be surprisingly high if you don’t maintain the required minimum balance, so do the math and make sure to select the right account for your financial situation.
If I were a betting man, I’d wager savings accounts are the most frequent first investments for Americans. I remember opening my first passbook savings account as a child with my parents at a bank branch at the local mall. I think they got a free toaster out of the deal, and I got a head start on a lifetime of relatively thrifty saving and investing habits!
Savings accounts are fairly easy to open at a physical bank branch or online, but the terms and conditions vary considerably, so you’ll want to do some research to make sure you are getting the best account for your financial situation. Because savings accounts are designed for saving money, rather than day-to-day transactions like a checking account, there may be limits on how many transactions you can complete before your bank starts charging additional fees.
Interest rates at traditional banks for savings accounts today can be as little as a few basis points (one basis point equals 1/100th of a percent, so 100 basis points equals 1%), while some online savings accounts currently offer APY’s well in excess of 1%. So there are lots of options out there!
Many of us have checking and savings accounts with the same bank, in which case the accounts are typically linked to one another. This should make it easy to transfer money from one account to another. From checking to savings when you have extra money you want to earn more interest on, or from savings to checking when you have a big bill coming up and want to avoid overdrawing your checking account.
Money Market Accounts
Money market accounts combine some of the features of both checking and savings accounts, and frequently offer higher interest rates than savings accounts.
“Sounds great,” you say. “I’ll just put all of my money into a money market account and get the best of both worlds!”
Unfortunately, there are always terms and conditions and potential costs, which you will need to consider. Typically, you can write at most three checks a month on a money market account, so you probably won’t be able to use one to replace your checking account. The minimum balance requirements for money market accounts are oftentimes larger than they are for savings accounts, so unless you have saved up a lot of money, a savings account may be a more practical option.
Interest rates offered by money market accounts are often tiered, meaning that the more money you have in your account, the higher the interest rate you will receive. For example, a money market account offered by one bank may have a minimum balance requirement of $10,000, and offer an APY of 0.50% on deposits between $10,000 and $25,000; an APY of 0.55% on deposits between $25,000 and $50,000; and an APY of 0.60% on deposits above $50,000.
There are lots of options to consider if you decide to open a money market account. The interest rate you earn can vary considerably by bank. As with savings accounts, you may find higher interest rates offered by online banks.
Certificates of Deposit (CDs)
A certificate of deposit (CD) is a bank deposit for a specific period of time, frequently between six months and five years. CDs often offer the highest interest rates and APYs of the bank products we have discussed, in part because you are giving up liquidity, which is the ability to quickly access the funds you have deposited. If you need your money back before the CD’s scheduled maturity date, you will likely incur an early withdrawal penalty, the terms of which – you guessed it! – are in the fine print of your agreement with the bank.
The bank can offer a higher rate on CDs because it knows the specific time period during which it will have access to your deposit to offer loans to others. There’s value in that to the bank in comparison to checking, savings, or money market accounts, in which you can usually withdrawal your money at a moment’s notice. CDs with longer terms typically (but not always) offer higher interest rates than CDs with shorter terms.
When your CD matures, you will receive your deposit (also known as your principal) back, in addition to the interest you have earned. Some CDs are set up to automatically roll over into a new CD of the same term as the one that just matured. While this can be convenient, keep in mind that interest rates change, and if you don’t pay attention, your money can get locked up again at a less attractive APY. Make sure your bank knows what you want to do with your money when your CD matures!
Because interest rates change over time, when your CD matures, you sometimes will be able to reinvest the money at a lower interest rate, and you sometimes will be able to reinvest the money at a higher interest rate. To hedge against this reinvestment risk, some investors use a strategy called a CD ladder.
In a CD ladder, instead of purchasing a $10,000 CD with a term of two years, you would split your investable assets up, putting, for example, $2,500 into a six-month CD, $2,500 into a one-year CD, $2,500 into a two-year CD, and $2,500 into a three-year CD. When the first CD matures after six months, you would then review your financial needs and current interest rates, and decide whether to reinvest your money in a new CD or invest it in something else. Using CD ladders will generally give you as an investor more options as your personal circumstances and the financial markets change. You won’t generally lock in all your money at very low rates, but you also won’t lock in all your money at very high rates either.
Thoughts About Inflation and Bank Products
Over the last decade in the United States, inflation, as measured by the consumer price index, has averaged about 1.8% per year. What that means is, unless you have earned more than 1.8% a year on average on your investments, the actual value of your portfolio, as measured by its buying power, has been decreasing.
Many economists expect US inflation this year to be around recent average levels of 1.8%, with most forecasts calling for a rate between 1.0% and 2.5%. Most bank products today are offering interest rates between 0% and 2%. Right now, it is difficult to keep up with inflation if all of your money is kept in bank products.
While you may be tempted to put your money into a CD for several years to lock in higher rates, you need to keep in mind that interest and inflation rates are always changing. Locking in at a 2.25% APY for five years today might seem like a good way to at least keep up with inflation over the next several years. But what happens to your buying power if you lock in for the medium term now, and then inflation rises significantly? From 1978 through 1982, annual inflation in the US averaged nearly 10%, and inflation was over 5% as recently as 1990. While the Federal Reserve has been focused on keeping inflation low for the past couple decades, there are no guarantees.
My Experience With Bank Products
As I mentioned earlier, I opened my first savings account when I was a child, and have had a variety of checking, savings, and money market accounts and CDs over the past several decades. Right now, our family has accounts with both traditional and online banks. The majority of our cash is in a credit union savings account earning about 1% a year, with smaller amounts in checking and savings accounts earning lower rates. While we could earn more if we put some of our cash into a CD, I’m not inclined to lock up my money for several years right now. If the eight-year bull market in US stocks comes to an end, I want to have some cash readily available to invest in the stock market at discounted levels.
That said, I know our investments in bank products are not keeping up with inflation at this time. I am considering moving some cash into a relatively short-dated CD ladder, with 25% invested for six months, 25% for one year, 25% for 18 months, and 25% for two years. This might enable us to generate a bit more interest income today, while still keeping our options open, with access to a portion of our cash every six months in case the stock market does present a more attractive buying opportunity.
Summary of Investing In Bank Products
FDIC-Insured bank products are among the lowest-risk investments available in the United States. Because of that, your potential returns, via interest payments, are also likely to be relatively low, and may in fact be negative in real terms after accounting for taxes and inflation.
The majority of us need a checking account and ATM/debit card to handle the day-to-day financial transactions that are part of modern life. Most of us should also try to have some emergency funds put away to handle life’s unexpected surprises, and a savings or money market account is often a fairly safe place to do that. Those who have built up more savings might consider investing in CDs.
Given the current interest rate environment, it is unlikely most people will build great wealth by keeping the majority of their assets in bank products, but there is something to be said about being able to sleep well at night. Even so, most people pursuing financial independence and early retirement ultimately decide to branch out into riskier investments like bonds, stocks, mutual funds, and real estate, in the hopes of generating higher returns that can beat inflation.
Next time around, we’ll discuss investing in bonds.
Retiring On My Terms is for informational and entertainment purposes only. We are not financial advisors. You are responsible for your own decisions. Before making any financial decisions, you should consider your own financial circumstances, and consult with a professional advisor.
What percentage of your portfolio do you keep in bank products? Do you plan on increasing or decreasing that amount over the next year? Why?