The Fed's rate hikes are boosting yields on CDs, money-market funds and savings accounts. Here's where you can find the best deals.
Good news for short-term investors: The interest rates offered on cash-based accounts — CDs, money-market funds and savings accounts — are finally starting to improve.
Since the Federal Reserve started raising rates last June, the federal funds rate has jumped from 1% to 2.75% (counting Tuesday's quarter-point increase). As a result, the average annual yield on money-market funds has gone from 0.75% a year ago to 1.98% as of March 15, according to iMoneyNet.com, an industry tracker. One-year CDs with a $2,500 investment now pay 2.36%, compared with 0.95% this time last year, according to Informa Research Services. And investors can now find annual rates of 3% or better on money-market savings accounts if they're willing to go with an Internet bank.
Here's a rundown of the most popular short-term savings options, along with details on how to take advantage of them in a rising-interest-rate environment.
Certificates of Deposit (CDs)
When interest rates are rising, investors should stay away from long-term CDs, says Certified Financial Planner Marilyn Bergen, owner of CMC Advisers in Portland, Ore.
Shorter-term CDs offer lower yields, but as interest rates go up and the CDs mature, investors can reinvest the money at more attractive rates. "I wouldn't recommend that people go past 12 months," says Bergen. She advises splitting money between six-month and 12-month CDs. (For some of the best current offers, see the table below. Keep in mind that these may include promotional rates offered only online through Bankrate.com. They might not be available at your local bank branch.)
Many banks are spicing up their CD offerings with special features that let you hike a CD's interest rate before it matures, says Randy Rosen, manager of deposit research at Informa Research Services. These are often called bump-up CDs, though some banks have other names for them. (At Bank of America, for example, they're called "opt-up" CDs.) The details vary by bank, but here are the basics: Say you buy a 12-month bump-up CD, and in a few months you notice that your bank is offering higher rates. You have the option to request a rate increase for your CD. This is something that you, the consumer, must initiate, explains Rosen.
Some banks impose certain restrictions, such as limiting you to one or two bump-ups, or not allowing you to do it within the first 30 or 60 days after buying the CD. In addition, some banks might automatically extend the term of your CD if you bump up the rate — so make sure you're familiar with the terms of the offer. These offers are typically meant to attract new customers, and might be more common with longer-term CDs (Bank of America's opt-up CDs, for example, have a 30-month term), though according to Rosen investors can find opt-up options on shorter-term products as well.
If you go with a CD, remember that you'll be hit with a penalty — typically part of the accrued interest — if you withdraw your money earlier. (For more on the basics of CDs, read our story.)
CD Pros: Interest rates are typically higher than those of money-market funds or money-market accounts.
CD Cons: Money can be locked in at a fixed interest rate that might not keep up with rates offered elsewhere; must invest in fixed increments.
Minimum must be $5,000 or lower
Bankrate.com rating must be three-star (performing) or higher
Money-Market Mutual Funds
Last year, money-market funds were the black sheep of short-term investments: They earned as little as 0.50% — a yield that investors could get with an ordinary savings account. Why take on risk by investing in a mutual fund when your FDIC-insured bank's ATM is just a drive away?
For one thing, yields are starting to increase, according to Peter Crane, vice president and managing editor of iMoneyNet's Money Fund Report. "We're coming out of a three-year period where bank savings out-yielded money market mutual funds," he says. Historically, money funds have beaten savings accounts by a full percentage point. With rates on the rise, this pattern is starting to get back to normal.
"You're looking at a fed funds target in the range of about 4% by year-end 2005," predicts Crane, "in which case money-market funds should be just under 3.5%. (Money funds typically lag the fed funds rate by about half a point, to cover the fund's expenses.) Banks, on the other hand, are expected to hang on to the lower interest rates a bit longer, Crane says, as they make up for not having dropped their yields much lower than 0.5% back when rates hit historic lows. "Banks were slow to cut rates on the way down and offered more attractive yields. But now, except for the most aggressive Internet banks, they're moving more slowly on the way up as well."
MMF Pros: Liquidity (many funds offer check-writing capability); interest rates catch up with the fed funds rate faster than money-market savings accounts.
MMF Cons: Investment risk. Money-market funds aren't federally insured, and can lose value.
Top Money-Market Funds (Taxable)
Average Yield: 1.98% as of March 15, 2005
These days, the yield on most savings accounts remains anemic at best — the average is less than 0.5%. But if you're comfortable using an Internet bank you can do significantly better than that. Internet banks these days are paying as much as 3.25% on accounts with little or no minimums and typically no annual fees. They can afford the higher yields because they don't have the overhead expenses of managing bricks-and-mortar branches.
This also means that instead of depositing your money at a bank branch or an ATM, you must handle all withdrawals or deposits through an existing checking account — often through a different bank. So if your checking account is with, say, Citibank, you could open an Internet savings account through ING and move funds back and forth online as needed.
Right now, the most attractive savings offer comes from the 155-year-old Emigrant Savings Bank in New York, which earlier this year launched an online division, EmigrantDirect.com. It currently offers a 3.25% rate on money-market accounts, and has no fees or minimum deposit requirements. According to John Hart, a vice chairman at the bank, the yield is not attached to the fed funds rate — and therefore it might not continue increasing throughout the year. But it is guaranteed not to decrease through the end of 2005.
Another high-rate offer comes from the better-known ING Direct, the U.S. division of the Dutch financial-services company ING Group. Currently, the ING savings accounts yields 2.8%. Capital One and GMAC offer yields of 3.1% and 2.75, respectively — although they impose small minimum deposit requirements of $100 and $500, respectively.
Attractive though these rates may be, many consumers still don't feel comfortable sending their cash into cyberspace. Nearly a third (32%) of the respondents to a recent online survey by Jupiter Research said they believed their money was more secure if the bank had a physical presence. In practice, however, these banks carry the same FDIC insurance as their bricks-and-mortar cousins.
For more high-rate money market account options, see the table below. The Bankrate.com ratings are meant to assess the safety and soundness of the institution: A rating of three stars and above indicates that the bank is performing in line with industry standards, according to a company spokesman.
MMA Pros: Low or no fees; small minimum investment requirements; high interest rates.
MMA Cons: The most attractive rates are offered by Internet banks that have no bricks-and-mortar branches. Many banks limit withdrawals to six per month.
High-Yield Bank Money-Market Accounts
National Average APY: 2.05%
Minimum must be $500 or lower
Bankrate.com rating must be three-star (performing) or higher