Deposits are a crucial part of any investment and savings plan. Although during a recession deposit accounts may pay considerably less interest due to low rates, bank deposits provide savers with a measure of safety that cannot be found elsewhere. Actively managing your deposit accounts will ensure that you know how these savings instruments work, a first step toward reaching your financial goals.
Basics
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The main objective of a deposit is to save money in a safe account. Savers normally use deposit accounts for the long range, although banks offer deposit products for terms as short as one week for a certain threshold of funds (normally at least $100,000). Depending on the saver's own appetite for risk, deposit accounts may be just a part of the portfolio, the bulk of the total savings plan or even the only investment made. The Federal Deposit Insurance Corporation (FDIC) reminds us that no depositor has ever lost even a penny of FDIC-insured accounts, an important consideration for conservative investors who want a safe place to put money, while earning modest interest rates.
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Types
Deposits help savers reach financial goals by providing a wide variety of account types. If the objective of deposits is to provide interest accrual in a safe environment, then many options are available from which to choose. Certificates of deposit, or CDs, are one of the most popular deposit types. CDs offer a fixed rate on a sum of money in return for a fixed-term commitment from the depositor. A large draw for CDs is flexibility; CD terms range from a week to 10 years or longer, generally paying the highest rates of return for the lengthiest terms. Although CD account owners may remove the interest as it accrues, withdrawals from principal amounts can trigger penalties.
By contrast, a savings account pays interest while also allowing the owner to make a certain amount of withdrawals per month without penalty. Savings accounts have historically paid lower interest rates than CDs, although this has changed in recent years with the popularity of money market savings accounts. Money markets pay banks higher rates of interest on the money they invest, allowing the banks to pass on the higher interest rate to deposit customers.
Function
Deposit accounts reach fulfillment of their objective by harnessing the time value of money. This means that as interest accrues it is "compounded," allowing you to earn interest on top of interest. Basically, if you have $1,000 in a savings account, and the account earns $30 in interest in a month, the next month the bank will pay you interest on $1,030 (provided you make no withdrawals).
Another key function of deposits is rate competitiveness. Because so many banks and other financial institutions offer deposit accounts, the saver is the beneficiary of a highly competitive environment. This means that, even in times of generally low interest rates, banks will always need and desire depositors, offering customers additional benefits and perks.
Strategies
Because of the sheer number of bank deposit options, savers can plan objectives based on varying term lengths and account types. For instance, a depositor can "ladder" a deposit of $9,000, breaking the sum into three $3,000 CDs, each coming due two months apart. This strategy relieves the saver from having the entire sum tied up for a longer period of time, creating flexibility.
Many depositors use savings and CDs as a supplement to monthly income (or, if you are fortunate enough to have large deposits, the entire monthly income). This interest income can be mailed to the depositor or transferred to a checking account. Just keep in mind that this strategy will reduce your long-term interest total normally accrued through compounding.
Considerations
Historically, CDs (including individual retirement account CDs) have paid the most interest, followed by savings accounts and then interest-bearing checking accounts. This order has changed significantly in recent years, as banks have found that CDs in particular provide relatively little revenue to banks. High-yield checking accounts, which pay rates comparative to savings accounts, have become increasingly popular. In summary, you should ask your banker what accounts are paying the best interest rates.
Another consideration is that deposit accounts' main objective of paying interest with safety does not guarantee high rates of return, especially compared with risk-inherent investments like stocks. During the recession that began in 2007, for instance, the government was loaning banks cheap money; this meant that banks did not require as many depositors, decreasing interest rates overall. Remember to consider safety and flexibility, along with interest rates, when planning your deposit savings goals.