Personal savings is the base of your financial pyramid. It is the foundation of your family's well-being and it's your starting point to building wealth. Starting a sound savings program isn't difficult, but it takes some thinking, planning, and commitment.
Your first savings priority should be to build the money you'll want on hand for immediate and short-term needs. This money could be for a specific upcoming expense like a vacation, an educational class for your children or anything you expect to pay for in the near future. In addition, you should set aside enough savings to serve as an emergency fund. An emergency fund is basic financial protection in the event of a medical emergency, household catastrophe, job loss, or other unforeseen expenses. Financial professionals generally suggest saving the equivalent of three to six months of your household expenses.
You need to devise a savings strategy that maximizes your return. What's the best place for your savings? Your initial choice may have been a traditional statement savings account at your bank; this is fine for many purposes but is not the only savings option that your bank offers. Knowing about the various options can help you build greater wealth for the future.
Savings Accounts, Money-Market Accounts, Certificate of Deposits
Savings accounts or "passbook" accounts have long been the classic place to start building your money. You receive interest on your funds and the Federal Deposit Insurance Corporation (FDIC) insures your savings for up to $100,000. Typically, the savings accounts yield low interest rates. And, over time, the rate you earn on a savings account may not keep up with inflation.
Money market accounts (MMAs) invest in short-term securities by the bank or investment firm managing the account. MMAs offer higher interest rates than a standard savings account, but usually requires a minimum balance, limits the number of withdrawals per month, and often charges a monthly service fee if the minimum balance isn't maintained. MMAs are also insured by FDIC and therefore considered a low risk investment.
A certificate of deposit (CD) is a short to medium-term, FDIC insured investment available at banks and savings and loan institutions. CDs are low-risk investments that yield a predetermined interest rate for a fixed period of time. It is important to know that if you choose to withdraw your money from a CD before it has matured you will pay a harsh penalty.
A fundamental concept to understand when buying a CD is the difference between annual percentage yield (APY) and annual percentage rate (APR). APY is the total amount of interest you earn in one year taking into account compound interest. APR is simply the stated interest you earn in one year, without taking compounding into account. Compounded interest is a great feature because it allows you to earn interest on your interest. For example, if you invest $1,000 in a CD that has 5% annual percentage yield (APY), then you will earn $50 in your first year. As long as you leave that $50 invested in your CD, then you will earn 5% interest on $1050 the following year.
- Elizabeth Pratt, Salary.com contributor