Seek the best returns for your hard-earned savings
(ARA) - More Americans are setting money aside in savings accounts these days, due to the financial crisis. And investing Americans have become more conservative, holding onto more cash than they might have in the past. Both trends are good ones and will lead to a stronger economy in the long run.
But with low interest rates on short-term CDs, money market funds and savings accounts hovering around zero percent, you may have difficulty finding an attractive place to park your savings.
Savers will have to be a little more creative to earn a respectable return. In light of this, it is helpful to explore some strategies to help make your cash work harder. However, you should carefully evaluate two potential issues with any strategy to boost returns on cash - the risk of losing your principal and earnings, and the accessibility of your funds. With this in mind, here are a few ways that you can earn returns that are higher than the 0.6 percent being paid by the average savings account:
1. Pay off debt. Before considering any of the options described here, think about paying off debt. Credit card balances or car loans with high interest rates are attractive options for deploying your cash, and best of all, provide a guaranteed return. The only drawback is that once you pay off debt, you lose access to the funds. Still, if you have set aside enough cash for an emergency fund, then using some of your cash to pay off debt is a very sensible option when interest rates on savings accounts and CDs are so low.
2. Buy a two-year CD. CD rates are at historic lows, but two-year CDs can provide an interest rate well above the typical savings account or money market fund. CDs are virtually risk-free if held to maturity and as long as you invest below the FDIC limits of $250,000 per individual, per institution. Buying a two-year CD also means that if interest rates rise, you will not have to wait very long until you can reinvest your money in a higher yielding CD or savings account.
3. Invest in a high quality short- or medium-term bond mutual fund. Buying a bond mutual fund that invests in highly rated bonds that mature in two to five years may provide higher returns than placing your savings in a money market fund or short-term CD. In addition, unlike a CD, your money is accessible at any time, though some bond funds may assess a modest early redemption fee. The major risk is that the value of your initial investment may go down, particularly if interest rates rise quickly. You can gauge this risk by finding out what a fund's duration is - the duration is a measure of how sensitive a fund is to changes in interest rates. For example, a fund with a duration of three years will fall approximately 3 percent if rates rose by one percentage point; a fund with a duration of five years would fall 5 percent if rates rose by one percentage point. While these declines are not dramatic, bond fund investors should be prepared to tolerate this level of volatility. The silver lining is that when interest rates rise and a bond fund falls in value, the future returns on the fund will also rise over time as the fund gets the opportunity to invest in higher yielding bonds. Fixed income securities are subject to interest rate risk, and their value will decline as interest rates rise.
4. Take a look at insurance products. You may already own a universal life insurance policy, either through work or a policy you purchased years ago. These products usually allow you to invest a certain amount each year, say 10 times your annual premium, in an account that will earn a guaranteed rate of return backed by the insurer. For some products, the guaranteed return is more than 4 percent today. The details will vary based on the product, so check with your insurance agent or employer.
Another insurance product that may make sense is a variable annuity. If you are approaching retirement, a variable annuity provides a means to convert cash that you may have set aside for retirement into a future stream of guaranteed retirement income. Many variable annuities, for an additional cost, will guarantee a steady increase, such as 5 percent each year, in the future retirement income that you can draw on the assets you invest for as long as you hold off on drawing your retirement income. However, it is important to keep in mind that while variable annuities guarantee you a future retirement income, the actual value of your assets held within such a product will fluctuate and can go down.
In addition, variable annuities have a broad range of features and contract terms, such as early withdrawal fees, to consider. A variable annuity is suitable for long-term investing, particularly retirement savings. It is best to speak to a knowledgeable financial advisor to evaluate whether a variable annuity is a suitable way to invest your cash. All guarantees are based on the claims-paying abilities of the issuer.
5. Invest in a stable value fund. Stable value funds are similar to high quality bond funds, but provide one added feature - a guarantee that you cannot lose your principal and accumulated earnings. These guarantees, which are dependent on the claims-paying ability of the issuing company, are usually backed by major insurers and even during 2008, stable value funds delivered an average return in excess of 4 percent, according to a Washington Post report. However, stable value funds are generally only available in 401(k) or similar accounts.
So, this may be a good time to consider whether you could benefit by contributing more money to your retirement accounts and investing these contributions in a stable value fund. An additional benefit of doing this is that the retirement account may be tax advantaged and either defer tax on contributions and earnings or, in the case of a Roth account, provide for income tax free earnings. The main drawback to this strategy is that your money will be harder to access once contributed to a retirement account, since taxes and penalties may be assessed on early withdrawals.
Maximizing returns on cash is likely to be an area of interest for households for years to come as Americans recalibrate their finances in the wake of the financial crisis. Interesting and effective options exist for maximizing returns on cash if you look beyond the traditional options of a money market fund or savings account. Choosing among these options requires carefully thinking about how much easily accessible cash you need for emergencies, what your long-term plans are for your cash, and what trade-offs in terms of risk and accessibility you are willing to live with.
Courtesy of ARAcontent