For the past decade, the interest rate provided by banks for a savings account has been putrid. When it didn’t seem like it could get worse, following the pandemic, the national average on savings deposits hit a startlingly low 0.04% . That means the $50,000 you have set aside earns $20/year interest (which is considered income and subject to tax).
So, what is a family to do today with that hard earned savings if they’re not happy with 0.04%?
First, we must remember, for an added return above and beyond 0.04%, we must accept some level of risk. There are many different types of risk, but for today’s conversation we are going to consider the following:
Liquidity Risk – This is the risk that you may not be able to immediately access your capital without penalty.
Credit Risk – Risk that a borrower is unable to pay the contractual interest or principal on the debt obligation.
Interest Rate Risk – The risk that an investment’s value will decline due to an increase in interest rates.
Given we now know we’ll have to bear some risk for our extra yield, here are some of the options available and the risks they’re subject to.
High Yield Savings Account
Just like many other industries, the internet has infiltrated the traditional banking system. One positive result is the introduction of high yield online savings accounts. Many of these online banks currently offer yields of more than10X the national average for savings accounts mentioned above. With this additional return there are some considerations:
Interest Rate Risk – Many online banks offer teaser rates or adjustable rates on their savings accounts. The result is the higher rate you once signed up for may not be offered months or years down the road.
Liquidity Risk – Unlike your local bank where you can walk in to see your local teller, many online banks have zero physical bank branches which means accessing your capital must be completed online and through the ATM system.
Paying Down Debt
Some families diligently have built up a 5-figure savings account, yet at the same time have saddled themselves with similar levels of credit card debt! The easy solution is to utilize some or all the money in the savings account to eliminate that credit card debt (or other high interest debt). As an example, the average credit card rate last year was 14.58% for existing account holders . If a family has $10,000 of credit card debt over the course of a year, they would be paying $1,458 in credit card interest, while at the same time their $10,000 in their savings account at the national average would earn $4 interest. Simply taking the $10,000 in the savings account to pay down that existing credit card debt would save them $1,454 per year. Risk to consider:
Liquidity Risk – If you use your entire savings account to pay down high interest debt, you know longer have access to that savings account in the event of an emergency.
Treasury Series I-Bonds
The Unites States Treasury will offer individuals a limited ($10,000 per social security number) amount of Series I-Savings Bonds for purchase. These bonds accrue interest (rather than pay monthly, quarterly, or annually) until redemption which can also defer taxable income. The interest rate on I-Bonds is made up of a combination of a fixed rate and inflation rate. As of this writing the fixed rate is 0.00%, but the inflation rate is 1.68% (bonds issued 11/20 – 4/21). The following risks among others should be considered:
Liquidity Risk – I-Bonds must be held for a minimum term of 1 year. If an individual tries to redeem the bond from year 1 to year 5 there is a penalty of 3 months interest. Thereafter there is no liquidity penalty.
Interest Rate Risk – The inflation rate component of Series I Bonds are variable, meaning there is a possibility the interest rate on your bond will drop in the future.
Investment Grade Short-Duration Bonds
Okay. Let’s break down some of the financial jargon in this group. First, all major entities (municipalities, states, nations, and companies) are graded based on their financial standing. According to Standard & Poor’s any rating above BB+ is considered investment grade. Next, duration is the length of time, in years, for an investor to be repaid the bond’s total cash flow, including principal repayment. Short duration does not have a set definition, but usually it means any bond with less than 3 to 5 years to maturity. Bonds can be purchased individually or through a mutual fund or ETF to help provide diversification. Risks here can include:
Credit Risk – Although investment grade is considered the highest credit rating, the rating agencies can downgrade a bond’s rating which in turn will, likely, hurt the immediate price of the bond or bond fund.
Interest Rate Risk – If interest rates were to rise, this means new bonds will look more attractive than the bonds you currently hold, thus pushing down the price of your bonds.
Multi Year Guarantee Annuity (MYGA)
A MYGA, much like a bank CD, offers investors a guaranteed fixed rate of interest for a finite term of years. Like Series I Bonds, the interest accrues until maturity which allows you to defer your taxes. MYGAs are an insurance product so the credit quality of the insurance carrier must be considered. Since you are giving up liquidity and foregoing the FDIC guarantee of a savings account, MYGAs pay a considerably higher interest rate. As discussed, some risks:
Liquidity Risk – For the commitment of a guaranteed rate, the insurance company will not provide liquidity without penalty for the term of the annuity. This can last 3 years or more. Additionally since this is an annuity product, accessing your capital before age 59 ½ will result in penalties.
There are many financial options for your capital that resides in a traditional savings account. It’s important that you understand as investors search for better return on capital, additional risks will accompany it.
If you are asking yourself this question the advisors at Innova Wealth Partners would be happy to discuss the various financial options with you and what risks you must consider.
1. St Louis Fed – https://fred.stlouisfed.org/graph/?g=pbTc
2. WalletHub – https://wallethub.com/edu/cc/average-credit-card-interest-rate/50841
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