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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35351  
Subject: Bond and F-I FAQs: Part 2 A Date: 2/14/2007 2:18 PM
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Savings and Money Market accounts sound boring and get lousy returns, why would I want to put money in one of those?
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• There was a time, well within the memory of those over age 50, when all that banks had to offer were Passbook Savings and Checking accounts.
---Savings accounts paid very little interest and you had to pay for checking, but you could move the money in and out easily by going to the bank and making deposits or withdrawals.
---Anyone wanting higher interest from principal preserving investments had to buy US Savings bonds or Treasury Bills (which was difficult for the average American).

• Money Market accounts, which became common in the late 1970s (when inflation and interest rates were soaring), changed all that, along with automatic teller machines (ATMs).
---Money market accounts paid much higher interest than savings accounts, generally in line with the yields of short-term Treasury Bills.
---Typically, Money Markets allowed for the writing of only a few checks per month on the account, and otherwise limited transactions (e.g., not allowing the use of ATMs, thus requiring a trip to the bank during banking hours), which kept banking costs down. They also required large minimum balances, again keeping down their costs.
---But, for anyone able to keep the required minimum deposits on hand, money market accounts replaced savings accounts as the basic vehicle to hold savings. (Over time, money markets have evolved into various hybrids, some banks and credit unions offering more than one option.)

• Recently, savings accounts have seen a renaissance, thanks to online banking.
---These online savings accounts have offered interest rates competitive with money markets.
---They are able to do so because they have lower operating expenses than brick and mortar banks and they take advantage of longer lag times when transferring money.
---Some online savings accounts have high minimum balances.
---Others have low minimums, while still paying much higher interest than has been typical from traditional passbook savings accounts.

• Brokerages usually use money market accounts as the transit point or clearing/sweep account for money going into and out of other investments.
---Historically, brokerage money market accounts, which are not FDIC insured, have paid less interest than those at banks and credit unions, their primary use being for moving assets held at the brokerage.
---However, the best rates vary, and recently (2005, 2006) some brokerage money markets have been very competitive with those of banks and credit unions.

• Both insured money market accounts and savings accounts keep your principal safe and pay interest.
---The interest usually is less than what can be earned in a CD, Treasury, or US Savings Bond (except, sometimes, when the yield curve is inverted or there are special, introductory, rates).
-----Money market accounts and savings accounts are, however, much more liquid—you don't have to pay early withdrawal penalties and you have quick access to the money (though exactly how quick varies), at least if you retain minimum deposits.

• Choosing which bank or credit union to use and which is preferable, a money market or a savings account, will depend on convenience, liquidity, and where you can get the best rate.
---If you are only keeping small amounts of money in the account for ongoing expenses and run-of-the-mill “emergencies” (e.g. the plumber, the unscheduled car repair), the convenience of a local brick and mortar bank or credit union might still win out.

• For those who want to keep substantial amounts of money in an account where the principal needs to be safe, the exact moment when the money is needed is uncertain, and money is gradually being accumulated—saving for a big-ticket item or a down-payment on a house are good examples—seeking a slightly higher interest rate with less convenience and liquidity probably is the better choice.

• For long-term principal-preserving purposes such as emergency/contingency funds or for “safe” retirement money, over time US Savings Bonds and/or a ladder of CDs that at worst have a small interest penalty will usually do better than money markets or savings accounts.

• Eligibility for joining credit unions is restricted, but it may be possible to join a credit union with good rates through the back door (notably the Pentagon Federal Credit Union, which sometimes has exceptional CD rates).


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Okay, So Savings Accounts and Money Markets Are High on Liquidity and Low on Interest, What about CDs?
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• CDs (Certificates of Deposit) are savings devices, generally issued by banks and credit unions, intended for longer savings periods than money market, checking, and savings accounts.

• CDs are issued with different maturities, typically ranging from 3 months to 5 years (some 10-year CDs do exist), usually paying a higher interest rate for longer maturities.

• CDs typically have minimum deposit amounts ($500 and $1000 are common, but sometimes as much as $10,000), and may pay a higher interest rate for very large amounts (e.g., $100,000), a.k.a., jumbo CDs.

• CDs normally have a penalty for early withdrawal (e.g., 6 months' interest for a 5-year CD, 3 months' interest for a 1-year CD. The exact penalties vary, so be sure you read the fine print.

• CD interest rates are usually listed as both the non-compounded rate and the compounded rate or APY.

• Some CDs will allow the interest to be paid into a money market or savings/checking account instead of being retained and compounded within the CD. This is important for those needing steady income.

• Although there is no guarantee this will continue, in recent years it has consistently been possible to find CDs that pay better interest than comparable maturity Treasury bonds, mortgage securities, or high rated corporate bonds.

• The best rates on CDs have been through specific credit unions (definitely not all credit unions), some of which can be joined even if you aren't automatically eligible, and online banks.
---Sometimes you can find a special rate (to attract customers).
---Rates can be found through bankrate.com http://www.bankrate.com/yho/compare_rates_home.asp (banks) and
http://www.bankrate.com/yho/rate/brm_cucdepsearch.asp?product=15 (credit unions)
---Also, check your local banks and credit unions, particularly for special offers.

• In taxable accounts, CDs are taxed at your marginal rate and have no tax advantages of any kind (so, comparisons with Treasury and US Savings bond need to take state and local tax-free advantages into account).

• Because of penalties for early withdrawal, CDs may not be appropriate if you might need the cash before they mature (e.g., for emergency funds) or need steady cash flow.

• Despite the penalties, CDs do provide some inflation protection, since you can cash them in, pay the penalty, and get a new, higher, interest rate.
---This only makes sense with longer maturity CDs, because it will take time for the higher interest rate to compensate for the penalty.

What about CD “Ladders”?

• To get better cash flow, as well average interest rates over time, you can build a “CD-ladder.”
---Ladders can also be built using bonds or a combination of CDs and bonds.
---This is especially important when you are nearing or in retirement, since you no longer have steady cash flow from your employment.
---Laddering gives you access to your principal, as well as to accumulated interest, even if you do decide to roll over all or most of the principal into another CD. (This is especially important for people who have reached a stage when they are drawing down principal.)
---By buying and rolling over CDs at different times, catching different interest rates, laddering provides a hedge against inflation.
---On the other hand, laddering does not let you lock in high yields for extended periods of time, when interest rates are high.

• If you are gradually putting money away, you can simply buy 5-year CDs, which normally pay higher interest rates, whenever new money comes available, eventually building a ladder of 5-year CDs that can be rolled over into new 5-year CDs as they mature (or the money can be used for expenses or other investments).
---A note of caution on laddering by buying CDs (or bonds/TIPS) when you have money available. The end result may be a ladder with missing rungs, because expenses (and hence savings) vary from year to year and during the annual cycle, where some expenditures tend to recur at the same time every year (e.g., Christmas bills, summer vacations, insurance premiums, taxes). To get the desired cash flow for when you expect to start using the savings, you may need to make some adjustments, using shorter maturities.

• If you have a large sum or money, you can build an “instant” CD ladder by breaking the lump sum into smaller amounts and buying CDs of different maturities, rolling them over into 5-year CDs as they mature.
---Usually, this will get you less interest than just putting the lump into a 5-year CD, but it has to be done at some point to get better liquidity over the long run.
---“Instant laddering” works best when the “yield curve” is flat (not too much rate difference between different maturities) or inverted.

• Some people are convinced, if interest rates are low, that it is best to buy shorter maturity CDs then roll them into longer ones as interest rates go up.
---If you think this way, be sure to calculate how soon and by how much rates would have to go up to compensate for the lower starting rate.

Are There Any Alternatives to Fixed Rate CDs in Case Interest Rates Do Go Up?

• Some institutions are now offering CD-like instruments that protect your principal, while providing for the possibility of an increase in dividend under certain conditions.

• A “bump-up” CD will increase the dividend if prevailing interest rates (on CDs or on Treasuries, depending on the institution) go up to a certain level, and some offer more than one “bump-up” opportunity.
---These CDs guarantee the initial APY until maturity, but because of the bump-up provision, the initial APY will be less than you would get on a similar maturity fixed-rate CD.
---This option should be compared with an instant ladder, using the same amount of principal (crunch the numbers!).

• Market-indexed CDs protect your principal, but base your dividend on how well their target stock index (typically the S&P 500) does.
---These differ on how they work. You may get a fixed rate minimum (below that being offered on fixed-rate CDs) with variable increases tied to market gains above the minimum (or higher). Or, there may be no minimum, with your dividend dependent on the market index alone.
---Market-indexed CDs will only pay out a % of market gains, and they may cap the gains on which they will pay any %. So, if you are tempted, it is especially important to read the fine print. For example, if the market return on which they pay a % is capped each year, as opposed to over the maturity of the CD, and if most of the market gains happen in just one or two of the years over the life of a CD, you may have little to show for your investment, even with a solid increase in the market index for the period.

Do Brokerages Sell CDs?

• Many brokerages sell “brokered CDs” from various banks.

• These CDs are really more like bonds.
---They pay out interest periodically, without the option of internal compounding, and if you want the money before the CD matures, you must sell it instead of cashing in and paying an interest penalty. (This will cost more than a penalty if interest rates are up.)

• Because brokerages can get CDs from different banks, they will usually have something available that has a fairly high rate, even if not as high as your could find shopping around.
---If convenience is an issue, it may be worth sacrificing a little yield for one stop shopping.

• By using different banks, through a brokerage account, you can get virtually unlimited FDIC insurance.
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