With interest rates nearly as low as they can go, most investors have looked to the stock market to maximize both their income and their expected long-term returns. But for short-term money needs, there's no good alternative to holding cash. Fortunately, some banks offer you much better rates than others.
The wisdom of having money in the bank
From an investing standpoint, holding cash doesn't make much sense right now. Given current rates, money that you have in anything from Treasury bills and checking accounts to short-term CDs won't earn you much more than just keeping greenbacks under your mattress. When you consider that even the meager returns you get on your cash is subject to income tax and that every penny you keep in cash is losing purchasing power to inflation, cash looks even less attractive. That's one reason why dividend-paying stocks have gotten so popular, with SPDR S&P Dividend ETF (NYSE: SDY ) managing more than $6 billion in assets for income-hungry investors.
But having cash on hand is a must for every successful financial plan. Here's why:
- Preparing for the unexpected. Everyone suffers financial setbacks. Whether it's an air conditioner that conks out when you need it the most or a car repair that turns out to be more expensive than you thought, having an emergency fund will avoid having an unexpected expense turn into a budget-buster.
- Keeping fresh ammunition. When stocks and bonds have had long bull runs and are fully valued, you may not want to invest in them right away. Holding cash while waiting for a pullback can help you make more from your investment later on.
So since keeping some cash makes sense, the next question is simple: where can you make your cash work the hardest for you?
Banks that pay you back
The New York Times recently published results of a study that looked at the rates that many banks paid on their savings and money market accounts over time. You'll often find temporary "teaser" rates from financial institutions, but they often only last a few months before dropping back to a relatively unattractive interest rate. In contrast, this study looked for banks with consistent records of above-average yields.
On the savings account side, the banking arms of Discover Financial (NYSE: DFS ) , American Express (NYSE: AXP ) , and Capital One (NYSE: COF ) topped the list, while Zions Bancorp (Nasdaq: ZION ) , Ally, and ING Direct all posted rates of 1% or more during the second quarter.
Money market bank accounts combine features of savings and checking accounts. You can access funds by check, but there may be a limit on the number of checks you can write in a given month. On the other hand, rates tend to be higher than on regular checking accounts.
Many of the same banks that had high savings rates also topped the money market list. But others, including Hudson City Bancorp (Nasdaq: HCBK ) , One West, and AIG's (NYSE: AIG ) banking arm, also reached the upper echelon with minimum rates of 1%.
Is it worth the effort?
You may wonder whether you should even bother setting up a high-yield savings or money market account. With rates at 1%, you're talking about less than $10 a month in interest even if you have $10,000 set aside.
But there are several reasons why having a separate cash account makes sense. First, interest aside, having money separate from the checking account you use for everyday transactions helps you avoid dipping into your emergency fund for non-emergency expenses. Second, rates may be low now, but they won't be forever. While 1% may not make a big difference to you, the 4% or 5% that you could have earned several years ago -- and may well earn again in the years to come -- is much more significant.
Be smart with your cash
Having too much cash in your investment accounts can be the kiss of death to your long-term returns. But you need liquid funds available at all times to make sure a minor unexpected mishap doesn't turn into a financial catastrophe. By choosing banks that pay strong returns while offering the safety of FDIC insurance, you'll make your money work as hard as it can for you.
If you have too much cash set aside, though, that's a completely different story. In that case, you may want to boost your income and your return with dividend stocks. Read the Fool's free special report on dividend stocks to get 13 strong ideas for your consideration.