Before you invest, take some time to understand all of your options beginning with the different types of investments and the characteristics of each. This seven-part series was designed to help fill in the blanks or act as a refresher so you can make smart investment choices.
There are three basic types of investments – cash, stocks, and bonds. All other investments represent a variation of one or more of these basic types. For example, CDs are a form of cash, and mutual funds may be a form of either of these individually or in combination. It’s important to choose investments you understand, and to make investment decisions based on your goals, your time frame, and your risk tolerance level.
Cash investments tend to be safe, liquid (little loss of the principle if you cash it in) investments that are easy to get to. Examples of cash investments include savings accounts, money market accounts and money market mutual funds, and CDs.
Most savings accounts compound interest, which means that your earnings are added to the balance to create a larger base on which future interest is paid. You generally begin to earn interest as soon as the money goes into your account, and that interest continues to accrue until you withdraw.
Online banks often offer higher interest rates than more traditional brick-and-mortar banks because they have lower overhead. Before deciding on a savings account, compare interest rates, along with other features, such as convenience of making deposits and withdrawals. Depending upon the amount you put into the account, even a small difference in the rate can result in a substantial difference in interest over time.
Money market accounts are similar to savings accounts, but may pay higher interest rates. They may also require a larger deposit to open an account, allow you to write a limited number of checks each month, and have different interest rates for different account balances,. For example, there may be one rate for balances below $10,000, a higher rate for balances between $10,000 and $25,000, and an even higher rate for $25,000 and above.
Money market mutual funds are similar to money market accounts in that they typically pay interest at about the same rate and many offer check-writing privileges. However, any check you write against the account may have to be for at least the required minimum, such as $500. One drawback is that money market funds, unlike money market accounts, are not FDIC insured, although some offer their own insurance. While fund companies try to keep their money market share price stable at $1 a share, there is the possibility you could lose some of your principal.
Because savings, money market accounts, and money market funds are liquid and some of the safest investments they make good vehicles to use to park your money until you decide how to invest it, to build an emergency fund, or have in reserve for short-term goals such as a down payment on a house. On the downside, because you are not taking much risk with your money, the return is generally lower than most other investments.
Up next, CDs and laddering – and I’ll reveal a little known risk of this type of investment.
Patricia Stallworth, CFP® and CDFA, is the president of PS Worth, a financial education company, the author of Minding Your Money, and the host of the Minding Your Money Minute™. Learn more by visiting MindingYourMoney.net.