Selecting the Right Savings Vehicle for Your Time Horizon
It makes sense that money set aside for emergencies would be saved in a different type of account than money being accumulated for a major purchase years down the road. Yet that simple principle — different savings vehicles for different needs — is routinely ignored. Many savers, either through ignorance or inertia, let their savings dollars languish in low-yield savings or no-yield checking accounts. We suggest you consider the following choices instead.
• Money Market Accounts. MMAs, available through banks, are a solid choice for an "emergency fund" (i.e., money that might be needed at any moment) and have the advantage of being insured by the FDIC. Usually, the best rates are found at online banks. Online MMAs let you create an electronic "link" to your regular checking account, giving you virtually instant access to your MMA savings in an emergency.
• Money Market Funds. Until recently MMFs — a type of mutual fund — have been the best choice for emergency savings, but right now MMF rates are at historic lows. MMFs provide instant liquidity through check-writing privileges, and are virtually as safe as bank MMAs, although they are not insured.
• 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're willing to commit to, the higher the interest rate you'll receive — although right now the spread between shorter- and longer-term rates is quite narrow. CDs carry penalties for early withdrawal, so they're best used for funds you're confident you won't need until a specified future date. (For more information, see our SMI article, Using Bank Certificates of Deposit to Build a Savings Ladder.)
• 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. The downside: the prices of bonds owned by these funds 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, however, the higher yields of short-term bonds usually compensate for any near-term losses created by rising rates.
• Mortgage-Backed Bond Funds. These funds, often referred to as GNMA (Ginnie Mae) funds, invest in mortgage-backed securities issued by the Government National Mortgage Association. Ginnie Maes are even more sensitive to interest-rate changes than short-term bonds and can definitely lose money in the near-term, so a longer holding period is critical. Historically the higher yields of these bonds have eventually more than compensated for any short-term losses caused by rising interest rates. This can take time though, so only choose them if your holding period is at least three years.
With rates being so low right now, the likely direction of rates in the months and years ahead is upward. If rates rise, MMFs and MMAs will immediately take advantage of those higher rates. CDs will lock you in at today's rates — which is good if rates fall further but not so good if rates rise.
Rather than choosing a savings vehicle based on interest rate expectations (rates are notoriously difficult to predict), it's better to base your decision on the time frame until you need the money. If you might need the money right away, keep it in an MMA or an MMF. If you won't need it for a couple of years, a short-term bond fund might be the better choice. For even longer time frames, consider mortgage-backed funds.
As with most investment decisions, thinking "inside-out" will usually provide better results than basing your decision on external factors such as the direction of interest rates. For more on this, see Make Sure Your Investment Decision-Making Is Inside-Out.
August 26, 2009
© Sound Mind Investing
Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective. 
Originally published August 19, 2009.
