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Financial Literacy 101: Where to put your savings

Third in a series for
Financial Literacy Month

During National Financial Literacy Month we're presenting a series of posts on basic principles of investing and personal finance. (Each post in the series can be identified by the orange character at right, working diligently on a financial plan.)

Here's post three — about choosing the most appropriate kind of account for different kinds of savings.

Money set aside for emergencies should be saved in a different type of account than money being accumulated for a major purchase years down the road. That simple and sensible guideline — different savings vehicles for different needs — is routinely ignored. Many people simply put all their savings in low-yielding bank savings account and leave it at that.

Consider the following range of choices instead.

Money Market Funds. A good MMF is a solid choice for an "emergency fund" — i.e., money that might be needed at any moment. MMFs provide instant liquidity through check-writing privileges.

True, MMF yields are at rock bottom right now, but for an emergency fund, you should be much less concerned with the return on your money than the return of your money. With MMFs you can get your money back quickly. As for safety, only one retail money market fund has lost money in the past 40 years.

Money Market Accounts. MMAs also work well for an emergency fund, and have the advantage of being insured (up to $250,000) by the FDIC.

The highest-paying MMAs are through online banks. Online MMAs let you create an electronic "link" to your regular checking account, giving you virtually instant access to your MMA savings in an emergency.

Certificates of Deposit (CDs). CDs require you to commit your money for a term of one month to five years. The longer the period you're willing to commit to, the higher the interest rate you'll receive.

CDs carry penalties for early withdrawal, so they're best used for funds you're confident you won't need until a specified future date.

Short-Term Bond Funds. If your savings won't be needed for two-to-three years, step up to higher-yielding short-term bond fund.

The downside: the prices of bonds owned by these funds can fall when interest rates rise. That makes them a somewhat risky proposition for savers with time frames of less than two years. If your savings goal is at least that far away, however, the higher yields of short-term bonds usually compensate for any near-term losses created by rising rates.

Mortgage-Backed Bond Funds. These funds, often referred to as GNMA (Ginnie Mae) funds, invest in mortgage-backed securities issued by the Government National Mortgage Association. Ginnie Maes are even more sensitive to interest rate changes than short-term bonds and can definitely lose money in the near-term, so a longer holding period is critical.

Historically, the higher yields of these bonds have eventually more than compensated for any short-term losses caused by rising interest rates. This can take time though, so only choose them if your holding period is at least three years.

A few things to keep in mind: any interest rate increases over the next few months will be good news for savers using MMFs and MMAs, while short-term bond funds will suffer initial losses. As for CDs, remember that buying now will lock you in at today's very low rates.

Although you need to be aware of how rate changes affect certain savings instruments, the easiest way to decide where to put your savings is to think about the time frame until you need the money. For money you may need right away, keep it in an MMF or MMA. For funds you probably won't need it for a couple of years, a short-term bond fund might be the best choice. For even longer time frames, consider mortgage-backed funds.

For more on this topic, see chapter 6 ("Investing Your Emergency Fund") and chapter 7 ("Investing Your Accumulation Fund") of The Sound Mind Investing Handbook (5th ed.) by Austin Pryor.

SMI's Financial Literacy 101 series

• Creating your own personal financial plan
• Save by paying yourself first
• Where to put your savings
• How much should you save for emergencies?
• The upside of index funds
• A simple and steady investing strategy
• Inside-out investing
• Making the 'right' investing decisions
• Your most important investing decision

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