Saving money is great first step towards financial independence. However, investing that money wisely accelerates the path to building wealth and early retirement. With interest rates so low, the money sitting in savings account earns next to nothing. If you are like me who regularly keeps aside money, here are a few alternatives to savings accounts that can help your money grow faster. While none of these return anything close to what you get in equities, sometimes there are shorter term goals that we need to save money for and these alternatives are perfect for earning a return that is better than regular savings account while still offering some or complete protection of principal.
Online Checking and Savings Accounts
Online savings or checking account is a good alternative to your typical big bank savings accounts and return significantly higher interest rate than typical big banks. Online banks do not have the costs associated with operating a physical banking location and they pass on savings to end consumers. It offers higher interest rate and is convenient because everything is just a few clicks or a phone call away. How about safety? If you are concerned about identity theft, you will find comfort in knowing that there are more chances of somebody stealing your identity with paper statements and other communication sent by bank to your home than online banking. The data on internet is much more secure and identity theft overall has been on a decline. With the first $500,000 insured by Federal Deposit Insurance Corporation (FDIC), you have the same protection as brick and mortar banks. Ally Bank is a good place to start and it offers 1% yield on their savings account. You can check other banks at bankrate.com.
Money Market Accounts
Just like in savings and checking accounts, funds in money-market accounts are also insured by Federal Deposit Insurance Corporation (FDIC) up to the limit allowed by the law. Money market accounts are great alternatives to savings accounts with more flexibility in how you can have access to funds including ability to write checks. Again, Ally Bank is a great online bank with solid reputation and is consistently among the most competitive in the country according to Bankrate.com. I have not opened a money market account with them but I would seriously consider if I were to open a money market account. The rates vary but are in the range of ~1%.
Certificate of Deposits
The rates on Certificate of Deposits (CDs) is slightly higher than savings and money-market accounts but you lock in your money for a fixed time. You can always withdraw early but there is usually a penalty that pretty much wipes out most of the gains you would get if you keep the money for full term. Again, a CD in an online bank will return higher yield than your typical brick and mortar bank. Capital One 360 is currently offering up to 2% yield on a 5-year CD and Ally Bank is offering 1.6%. A good option is to stagger the Certificate of Deposits (CDs) with different time periods if you think you might need the money sooner than maturity.
Medium Risk Options
High-Yield Short-Term Bonds
If you are looking for higher returns than what is offered by savings or money-market accounts, short-term bonds are a great place to park your money now. While not as secure as savings account, you will have potential to get higher returns as these bonds pay out based on the market conditions. Short-term bonds usually mature in terms within 2 years or less, which can make them an ideal choice for investors with that type of timeline. You’ll need a brokerage account like Betterment, ETrade or to be able to trade bond funds and ETFs. Vanguard short-term bond ETF is also a good choice to start.
Treasury Inflation Protected Securities (TIPS)
Treasury Inflation Protected Securities (TIPS) are securities issued by U.S. Treasury and are indexed to inflation. TIPS offer a fixed interest rate but the underlying value of TIPS rises based on inflation. The best way to invest in TIPS is to buy an index fund that tracks TIPS. Funds focused on shorter-term (5-year) TIPS can offer inflation protection with less interest-rate risk as the interest rates rise. Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) is a great index fund to buy TIPS or you can buy TIPS directly from the government at TreasuryDirect.gov.
Muni Bonds and Corporate Bonds
Muni bonds are debt instruments issued by city and local governments where as corporate bonds are issued by corporations. They are normally used to raise money for capital investment in local projects such as schools, streets and highways, bridges, hospitals, public housing, and utilities. Muni bonds are perfect for investors who are in high-tax bracket because they are exempt from federal taxes. This is true of most people in tech industry like me, especially if you have double income and for a lot of other high-income professionals. Here is California, there are certain Muni bonds that are exempt from state taxes as well. Municipal bonds bear interest which is paid at either a fixed or variable rate, depending on the terms of the bond. The issuer of the bond (i.e. the local government) receives a cash payment from the investor in return for agreeing to pay the scheduled rate of interest to the bond holder.
Higher Risk Options
If you are looking for a slightly longer (3 to 5 years) time horizon and can endure some risk of higher return, investing in a balanced fund like Vanguard Balanced Index Fund Investor Shares(VBINX) is a great idea. It is a blend of 60% stocks 40% bonds, which has potential to yield higher returns than 100% bonds but also introduce volatility to your portfolio. The other way to invest in balanced funds is by opening an account at Betterment or a brokerage account at a discount brokerage fund like Tradeking. One should only invest in a balanced fund if you are looking at longer time horizon and can live without access to your money in case the market goes down when you need to withdraw.
I have some accounts in India (benefit of having ties to another country) which yield about 6.5% on Certificate of Deposits (CDs). This might be an option if you already have some funds in foreign currency and do not need it for some time. But overseas accounts have their downsides too, the biggest one being the exchange rate risk. With interest rates going up, the dollar is going to be stronger, which means the future exchange rate at which you will bring the funds back to U.S. might be unfavorable. I make frequent trips to India and I am planning to use these funds in Indian currency rather than bringing them back to U.S.
Peer to Peer Lending
Peer-to-peer lending sites like Lending Club and Prosper connect investors with borrowers through an online platform. The investors choose which loans they want to invest in based on borrower characteristics and interest rate. This is a great alternative to keeping your money in bank or traditional investments and could be a great alternative investment. It is inherently riskier however than other traditional investments and should be considered like a junk bond with no guarantee or collateral if the borrower were to default on the loan.
The best way to create wealth and achieve financial independence is to save as much as possible and invest in low-cost diversified funds. Create a system that automates these savings and you will achieve your financial goals faster.
If you are a DIY investor like I am who likes to keep things simple and diversified, you need to check out Betterment. For about 0.25% fees ($250 per year for $100,000 invested), you will get simple, diversified, automated investing. Betterment also makes it really easy to track your investment goals and provides additional benefits like tax loss harvesting. Just for that feature alone, I find their fees worth it.
If you are just getting started with investing, then you definitely need to check out Betterment. It’s what I recommend to my family and friends who aren’t strong investors or don’t care to learn about asset allocations, diversification, or rebalancing.