Weighing the Options for Guaranteed Return
Venturing beyond money market and online savings accounts? Weigh the pros and cons--and read the fine print--first.
Investors who were waiting patiently for higher yields on guaranteed investments might have to summon even more patience in the months to come. Worries over a contagion effect from China's slowing growth have stoked demand for safe securities, depressing their yields along with expectations that the Federal Reserve would likely start raising interest rates this September.
The rationale behind the Fed's zero-interest-rate policy has been to encourage investors to take more risks, getting them investing in their businesses and/or in the public markets rather than hunkering down in cash. And indeed, investors who have ventured beyond cash and into stocks, bonds, and most other assets since the financial crisis have been amply rewarded, while the poor cash investor has had to settle for ever-lower yields.
That's an argument for not staking more in guaranteed investments than you absolutely need to, as yields are currently so low on cash investments that they're a losing proposition once inflation is factored in. But it's not a rationale for giving up on guaranteed investments altogether. As the past few weeks have amply demonstrated, stocks are far too volatile to be an appropriate parking place for money you expect to tap in the near future. Bonds, while not nearly so volatile, also carry the potential for price fluctuations, perhaps even major ones, depending on the credit quality and interest-rate sensitivity of the bond investment. Investors who have near-term cash flow needs--whether for near-term retirement spending, to serve as a buffer against job loss, or to pounce on undervalued securities should they bubble up from the ongoing market turmoil--are best off holding true cash instruments.
But where to go for the highest possible guaranteed return? Money market accounts and so-called "high-yield" savings accounts, especially those offered by online savings banks that don't need to support a bricks-and-mortar presence, will tend to offer the best combination of guaranteed yield and liquidity today. Investors can currently obtain yields of 1% or even more with the best yielding of these accounts, as well as FDIC protections up to the current limits. (Money market mutual funds, by contrast, aren't FDIC-insured and generally have lower yields than high-yield savings and money market accounts today, though in the future their yields may beat FDIC-insured products'.)
High-yield savings and money market accounts also offer ready access to your cash, making them a good choice if you need to fund ongoing living expenses or defray other very near-term costs, or if you are holding dry powder while waiting for buying opportunities in stocks and bonds. (Money market accounts typically offer creature comforts like check-writing and debit cards, whereas high-yield savings accounts may not.)
If you're seeking a higher return than these accounts offer, remember that there's no free lunch. Here's a look at investors' possible avenues for their short-term cash, as well as the potential drawbacks associated with each.
While yields on longer-term CDs can be tantalizing, the drawback is liquidity: You'll pay a penalty, usually equal to several months' worth of interest, to withdraw your money prematurely. (In the past, some banks offered longer-term CDs with high yields and very light penalties on withdrawals, but those deals have largely evaporated, unfortunately.) That makes CDs inappropriate for investors with very short time horizons. Moreover, if interest rates trend up, the CD holder needs to stay put or face a penalty, though one workaround is to buy CDs with varying maturities--anywhere from three months to five years--to allow for reinvestment at different interest rates.
Credit unions are not for profit and, instead, are owned and controlled by their members. Most don't advertise, and they may not have bricks-and-mortar branches. Taken together, those qualities mean that yields on high-yield checking and savings accounts at credit unions are frequently higher than yields on guaranteed investment types offered by for-profit institutions. As with high-yield savings and money market accounts offered by for-profit institutions, it pays to read the fine print before signing on with a credit union in order to earn a higher yield on your money. It may be that the tantalizing yield applies only to balances under a certain level, often as low as $15,000. In addition, you may need to maintain a minimum balance or conduct a specific number of transactions per month to qualify for that yield. And not all credit unions are open to all comers; you may need to be part of a group or organization to take advantage of those higher yields. It's also worth noting that accounts at credit unions are not FDIC-insured but rather are insured by another entity, the National Credit Union Administration. Finally, while some credit unions have ATMs or give their clients ATM privileges at certain banks, not all do. This article provides more details on credit unions.
While stable-value funds' yields are not high in absolute terms--about 2%, on average, in 2014--they are higher than the yields on many competing cash instruments. That's because these funds invest in bonds and, thus, can pump out higher yields than true cash instruments, while also employing insurance wrappers to help keep their net asset values stable. The potential drawbacks of stable-value funds are twofold. First, stable-value funds are only available within the confines of company retirement plans like 401(k)s, so unless your withdrawal from such a plan meets certain criteria, you'll pay a penalty plus ordinary income tax to take your money out prior to retirement. Thus, stable-value funds fall short on the liquidity front for most investors, though they still may be reasonable choices as part of a strategic asset-allocation plan. Second, even though stable-value funds buy insurance wrappers to help protect investors' principals the assets aren't guaranteed or eligible for FDIC protections. This article provides more detail on the pros and cons of stable-value funds.
True, prepaying a mortgage doesn't provide the same cash return that the aforementioned vehicles do. And even though prepaying a mortgage helps build up your equity in your home, that money can't readily be tapped in the same way a cash account can, so mortgage paydown fails the liquidity test. But mortgage paydown does provide a guaranteed return that can be attractive in uncertain times and potentially overvalued stock and bond markets. After all, if you pay more on your mortgage than you're actually required to, it's possible to greatly reduce your interest costs over your loan's term, and that "return" on your money is guaranteed. From that standpoint, prepaying even a very low-rate mortgage of, say, 3% is going to provide a better return than you can earn by investing in a cash instrument. This article delves into Morningstar.com readers' takes on the wisdom of mortgage prepayment.