A key principle of maximizing your savings is to choose the savings vehicle based on your expected time-frame. It makes sense intuitively that money set aside for emergencies would be saved in a different type of account than money being accumulated for a major purchase several years down the road. Yet many savers, either through inertia or ignorance, let their savings dollars languish in low- or no-yield savings and checking accounts. Instead, savers should consider the following choices.

• Money Market Funds. A good MMF is usually the best choice for money that might be needed at any moment (your emergency fund). That's because MMFs provide instant liquidity through check-writing privileges, and are virtually as safe as bank money market accounts. But because they carry so little risk, they tend to be among the lowest yielding savings tools. In fact, with interest rates at historic lows over the past few years, money market funds have been in the unusual position of yielding less than bank money market accounts. Don't expect that to last. The Fed has already raised short-term interest rates three times, and more hikes are likely. As they arrive, MMFs should regain their typical position of yielding 1.0%-1.5% more than bank money market accounts.

• Certificates of Deposit (CDs). CDs require you to commit your money for a term of one month to five years. The longer the period you'll commit to, the higher the interest rate you'll receive. Because CDs carry penalties for early withdrawal, they're really only appropriate for money you're confident you won't need until a specified future date. With short-term interest rates on the rise, it makes sense to stick with short-term CDs. (For more information, see Using Bank Certificates of Deposit to Build a Savings Ladder.)

• Ultra Short-Term Bond Funds. These funds represent a small step up the risk ladder from CDs. That's because the rate of return you'll receive is uncertain when you invest, and you could even end up losing money. If you need to be certain you'll have a specific dollar amount on a given date, CDs are the best choice. But if you're willing to allow a small level of variability, ultra short-term bond funds will usually produce a better return over holding periods of 6-12 months.

• Short-Term Bond Funds. If your savings won't be needed for two to three years, step up to a short-term bond fund. Bonds with longer maturities pay higher yields, which is how these funds produce higher returns. However, the prices of the bonds they own can fall when interest rates rise. That makes them a somewhat risky proposition for savers with time frames of less than two years. If your savings goal is at least that far away though, the higher yields of these bonds usually compensates for any short-term losses created by rising interest rates.

• Mortgage-Backed Bond Funds. These funds, often referred to as GNMA funds, are more sensitive to interest rate changes. Because they can definitely lose money in the short-term, a longer holding period is critical. As with short-term bonds though, in the past the higher yields of GNMA bonds have more than compensated for any losses caused by rising interest rates, provided a holding period of at least four years.

Given the likelihood of rising interest rates over the next year or two, it makes sense to be conservative in your savings choices right now. Here's an example of how to apply that conservative approach. If you were planning to replace your car, and were sure that it wasn't going to happen for at least two years, we would recommend using a short-term bond fund. But if you're on the fence as to whether you might need to replace the car a little sooner than that, we'd recommend leaning towards caution and using the ultra short-term bond fund instead. That way if interest rates do rise and you have to pull your money out sooner, you're less likely to do so at a loss (or severely muted gain).

It's worth noting that four of the five instruments listed above are designed to automatically take advantage of higher interest rates. MMFs will reflect the higher rates almost immediately, with no downside. The three types of bond funds will all react negatively to higher rates in the short-term (the shorter the term, the less severe the reaction), but all three will gradually benefit as they replace lower yielding bonds with those carrying the higher new rates. But CDs won't automatically benefit. With a CD, you lock in the interest rate at the beginning. So while a rise in interest rates won't hurt you, you won't benefit either until it's time to renew with a new CD. Because it appears virtually certain short-term interest rates will head higher in the near future, it makes sense to either avoid CDs for now, or use a series of short-term (3-month or less) CDs rather than locking in for a longer term at today's rates. That way, as rates go up you'll benefit sooner rather than later.


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