Where to Park Short-Term Savings

Nobody likes leaving money sitting around in a 0.10% interest savings account. It creates a nagging feeling that we could be doing more to grow our pile. Yet, at the same time many of us have short term saving goals and aren’t that interested in risking the capital. Enter cognitive dissonance when your mind tries to hold two competing thoughts at the same time (I must get a good return on this money! I must not lose the principal!).

Posts like this need to be written every 6-12 months because the landscape is constantly changing. But if you’re looking to park some cash today and want to get a decent return without taking on much risk, here’s some ideas.

Should you even read this post?

I might save you some time right now. Should you even be reading this post?

Let’s say you have $10,000 for a short term goal. You’re earning 0.15% interest today in your bank’s saving account. This pains you and so you’re looking for something better. Let’s say you find something that you’re comfortable with that pays 3%. After taking on whatever risk entails getting a 3% return (and it won’t be a free lunch), you’re making an extra $285 a year ($10,000 x (0.03 – 0.0015)). Is $285 worth the risk and hassle of another account? It’s not even $285 since you’ll pay ordinary income taxes on the amount that you earn. After taxes, you might be looking at something more like $190 in cash each year. That hardly seems worth dealing with a new account, new login, etc.

On the other hand, maybe you have $200,000 as a down payment for a future condo purchase. On $200,000 the difference between a 3% return and a 0.15% return is $5,700 a year (before taxes). For something in that range, I’d definitely consider opening a new account and spending some time figuring out an optimal return.

Just make sure you’re focused on the right goal. If you have $10,000 in an emergency fund and worried about getting the best interest rate, I’d stop reading this article and take some steps to boost your savings rate.

Short-term savings options

Savings account

The easiest option that maintains 100% liquidity would be to open up a savings account at a place like Ally Bank. As of the date of this post they’re paying 1.20% APY. That’s not to say that Ally is the highest interest rate option. The banks are constantly jockeying back and forth in this respect. You might be able to find an account paying 1.31% (EverBank) but in my anecdotal review of this stuff, Ally is pretty consistently near the top. Unless you want to be opening up accounts and transferring around your money, I’d rather have an account that pays in the top 80% that I never have to think about again. Similar to Ally, Capital One (formerly ING) traditionally offers high rates and is paying 1.20% in money market accounts today.

Opening up a “high” interest savings account at a play like Ally or CapitalOne is a pretty convenient option for parking short term cash. There are no fees for the accounts and they are linked to your checking account. Moving money back and forth typically takes 2-3 days, so it’s about as liquid as you can get. For the vast majority of emergency funds (assuming you decide to keep one in cash), a simple account like this gets the job done even if you’re still losing real purchasing power thanks to inflation.

Short-term certificate of deposits

If you’re willing to give up some liquidity or at least forfeit some of your interest if you need the money sooner, CDs pay slightly better than online savings accounts.

For example, Capital One offers 2.30% for a 5 year CD. This is slightly ahead of inflation (but questionable whether you’re beating inflation after taxes). Like many banks, you’ll pay an early termination penalty if you break the CD before the 5 years is up. For Capital One, they’ll dock you 6 months of interest regardless of whether you’ve earned the interest (which means that if you terminate the CD in the first 6 months you’ll actually see a reduction in principal). It’s hard to get excited about locking your money up for 5 years with a 2.30% return.

Ally Bank offers a “no penalty” CD product. As its name suggests, you can withdraw the interest and principal at any time with no penalty. This makes it pretty similar to an online savings account. An 11-month CD for 1.50% is a better deal than their online savings account, so it’s hard to imagine picking it over the CD. The only catch is that you need at least $25,000 to get the 1.50% rate.

Municipal tax free bonds

By now you’ve probably realized that traditional high interest savings accounts don’t pay very much (in fact, you probably knew that before reading this article). If you’re not taking on any risk, there’s not a lot of reward to be found these days.

Before you proceed any further, you really should evaluate whether you’re willing to take on any risk with the funds you’re considering. Have you evaluated this money holistically as part of your Investment Policy Statement?

If you lost 10% of the principal over the course of the next two years, what would happen to your short term savings goal. Would it delay purchasing a house? And, if so, would you be okay spending another 6-12 months saving for a house purchase if that were the case?

Higher up on the risk ladder are municipal bonds. Municipal bonds are short term debt instruments issued by state, city and local governments to finance day-to-day operations or capital projects. Most municipal bonds are free from federal taxes (except. If you buy a bond that’s issued to the state or city government where you live, you’ll also probably avoid paying city and state taxes too. For that reason, a lot of high-income professionals are attracted to municipal bonds if they live in high tax states like California or New York (i.e. bunches of lawyers).

For example, if you live in New York like me you can invest in Vanguard’s New York Long-Term Tax-Exempt Fund. The fund is a collection of municipal bonds with an average duration of 6-10 years. It currently has an SEC yield of 2.11% although it has a one year annual trailing return of 0.91%. That’s because as interest rates rise, the price of your bonds go down and municipal bonds (like any bonds) are subject to changes in interest rate risk (as well as credit risk).

So while you may get a tax-free return that beats an online savings account, you are taking on some risk and have to be comfortable with seeing your account balance drop.

Bond and equity funds

If you’re comfortable with taking on some equity risk, there are several index funds funds that offer a mix of bonds and stocks. For example, the Vanguard LifeStrategy Fund family offers three options: (1) an income fund with a 80/20 mix of bonds and stocks; (2) a moderate growth fund with a 60/40 mix of stocks and bonds and (3) a growth fund with an 80/20 mix of stocks and bonds.

Of course with such a high exposure to equity, you need to be prepared for principal loss. Let’s say that you make an assumption that stocks could lose 50% of their value and bonds could lose 20% of their value in a major downturn. If you have a 80/20 bond and stock investment, then you should prepare for losing 16% of your principal thanks to the bond downturn and 10% of your principal due to the stock downturn. Are you comfortable being 26% down with this money? What if that means your dream home is an extra 2 years away? If that risk is worth potentially earning a 3.28% (pre-tax return) (the 1 year historical performance of the LifeStrategy Income Fund), then funds like this might be a good place for short term savings goals.

Reward checking and 5% savings accounts

If you’re willing to hustle, there are a few ways to earn even more cash with less risk:

• Reward Checking Accounts. These checking accounts offer 3-5% interest if you’re willing to put up with some hassle like initiating direct deposit of your paycheck, making 10 or more debt transactions per month, etc. The catch is that sometimes these accounts will only offer the rates on balances up to a certain ceiling (like $10,000).
• 5% Savings Accounts. I couldn’t even begin to explain how the Financial Panther has set up a system to earn 5% interest on $50,000. But like everything he does, if you’re willing to hustle, the reward is there. Here’s his step by step guide to earn 5% interest.

Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money and is always negotiating better student loan refinancing bonuses for readers of the site.