ELI5

Banks offer three main types of investment products – savings accounts, money market accounts, certificate of deposits (CDs). In the world of investing, these three are generally the safest forms of investments with varying amounts of interest opportunities.

The biggest benefit regarding savings and CD’s are that the money is insured by the Federal Deposit Insurance Corporation or FDIC. The value is dependent on the type of account you have, but we can delve into that later. For single accounts, the total deposits across checkings and savings accounts (in the individual’s name) are insured up to $250,000.

Savings accounts are the most basic account types offered by banks. They have a fairly low, minimum deposit requirement and offer decent liquidity. On top of that, they offer a small interest payment on the principal that is typically compounded. An individual can also withdraw money without any restrictions or penalties.

Money market accounts offer similar privileges to a savings account but typically have higher interest rates. They also have a minimum deposit, but can offer interest rates ranging from 0.1-1.0%. However, there are limits as to the amount of money and frequency that money can be withdrawn from an MMA.

Certificate of deposits are similar to the above accounts, but are an example of time deposits. They exist for a fixed period of time (3 month to multiple years) and pay interest regularly until time is up (or the CD is matured). The money is illiquid, so nothing can be added to or removed from the CD during the active term. So why buy a CD? Interest rates are higher compared to standard savings and money market accounts.

 

Detailed Definition

In order of savings accounts to money market accounts to CD’s they have progressively higher interest rates with decreasing liquidity. Let’s dive a little deeper into each type of account.

The main takeaway for savings accounts is that they generate interest, just not very much — the average APY is around 0.06%. Certain online banks offer higher interest rates (such as Ally) with rates almost as high as 2%. They can afford to do this since they have significantly less operational costs compared to brick and mortar banks. Another exception is that individuals can capitalize on promotions when opening a new account as banks offer better rates to attract new customers.

With savings accounts, it is important to make sure the minimum deposit is met typically on a monthly basis. If the account holder fails to do so, they will be charged a penalty fee. The other main downside is that though you can typically deposit money freely, withdrawals tend to be limited on a monthly basis.

Other than that, the main philosophy of a savings account is to keep the money and in theory not touch it, which lends itself to being a good investment vehicle for an emergency, or rainy day, fund. Savings accounts are the de-facto choice for risk-averse investors.

Money market accounts typically provide higher interest rates, but they come with a handful of downsides. As mentioned before, they have even tighter withdrawal abilities when compared to a savings accounts and also typically require a higher account minimum balance. Ultimately this higher balance is what enables the banks to offer the higher interest rates.

The money deposited is invested in conservative financial instruments – certificate of deposits, government securities (US T-bills) to name some.  Money market funds are regulated by the SEC and are mandated to only invest in short-term, highly rated debt. MMA’s are seen as a sound alternative to a traditional savings account assuming the person is willing to bear a nominally higher risk level.

Last but not least certificate of deposits tend to provide high interest rates that are (normally) static during the term of the investment, but provide no liquidity. By that, you can’t write a check or withdraw money from a CD account, unless you are willing to incur a penalty.

Another typical fact about these accounts – the longer the term, the higher the interest rate you’ll receive. Why? The individual is exposed to higher risk when holding onto this investment for a longer period of time, so they expect to be compensated proportionally. At the end of the CD’s term, you have the option to withdraw your money or roll it over into another CD.

Leave a Reply

Your email address will not be published.