A steaming hot cup of coffee perks you up and delivers a nice dose of antioxidants. But that same cup of joe can also raise your blood pressure and make you jittery. The Fed's recent cut to interest rates has similarly competing effects -- it reduces the cost of borrowing, but also slashes the yields in your cash savings accounts.
Before coronavirus descended upon us, the average savings account balance in the U.S. was $16,420, according to one report from Magnify Money. In the absence of a global pandemic, that's a decent-sized savings balance for a household that spends $5,000 or less each month on living expenses. But when you're worried about recession, every cent counts -- including the cents you earn on those cash savings.
Now's the time to optimize your emergency fund reserves and longer-term cash deposits. Here are four options.
1. High-yield savings account (HYSA)
An HYSA is far and away your most flexible option, and a popular choice for holding emergency funds. It's liquid cash, and there are no restrictions on how or when you access your money. Unfortunately, yields on these accounts have been impacted by the recent rate cut, with some banks lowering rates a full 1%.
There's good news and bad news here. If you are currently earning less than 0.1% in a traditional savings account, you'll get an earnings boost by switching to an HYSA. But if you're already in an HYSA, you're stuck with lower yields. Even the banks that haven't yet lowered their rates will eventually follow the Fed's lead.
2. Money market account (MMA)
Another liquid option is an MMA. Like HYSAs, MMAs offer higher yields than standard savings accounts. And although MMA rates are also heading south, you can shop around to find rates that will edge out the best HYSAs. There's often a minimum balance requirement for the best rates.
The main difference between an MMA and an HYSA involves how and when you access your funds. You can tap into your savings account anytime using a debit card or an online transfer to your checking account. Your MMA may offer those same features, plus a checkbook -- but you are subject to withdrawal limitations. Your bank defines those rules, but you're usually limited to six total withdrawals of any amount each month. If you exceed that number, you'll be charged a fee.
MMAs don't work well if you tap your cash savings often, say, to smooth out irregular income. But they are appropriate for emergency funds. Just plan ahead to work around that withdrawal limitation.
3. Certificates of deposit (CDs)
You earn a fixed interest rate on a CD, but in return, you agree not to access your money for a stated period of time. Rates on CDs with six-month or one-year terms are often lower than what you'd earn in an MMA or an HYSA. You could, however, beat your MMA yield with a CD that matures in three years or more.
Locking up your emergency funds for three years obviously isn't a good idea. But you could use CDs for money you don't need for a few years. You might plan on buying a home or car in three years, for example. That timeline is too short for the stock market, but just right for a three-year CD.
CDs are also predictable. Once you lock in the rate, it doesn't change. The only tricky part is that you can't add to your CD. If you are actively saving, you'd have to buy new CDs regularly. That's doable, as long as you keep an eye on when you'll need the money and time your CD maturities accordingly.
4. Ultra short-term bond funds or ETFs
Ultra short-term bond funds and ETFs invest in debt securities with maturities of less than one year. Thanks to those short maturities, these funds have low sensitivity to interest rate changes. And their yields are reasonable -- between 1% and 3% between 2017 and 2019. Historically, investors have gravitated toward these funds to increase their earnings on excess cash.
Any type of fund, however, has substantially more risk than a cash deposit. All three types of bank accounts above have FDIC insurance up to $250,000, so you don't have to worry about losing your money even if the bank fails. The same isn't true for some ultra short-term bond funds that invest in companies that could default on their debt.
Moreover, even if no bonds default, you can still lose money with a bond fund. Even these ultra short debt funds, once considered fairly safe, are showing losses of 2% to 8% in the first quarter of this year. That's not bad relative to the S&P 500's loss of roughly 25% in the same time period -- but it is bad compared to a CD which holds its value.
Especially in this environment, it doesn't make sense to chase yields at the expense of liquidity. If you have excess cash in a brokerage account and you're not comfortable increasing riskier positions, you might add ultra short-term bond funds as a stabilizing force in your portfolio. Only choose funds with low expense ratios that hold investment-grade debt only.
Manage yields and liquidity
The interest rate environment has changed, for better and worse, thanks to the Fed's recent cuts. You can't avoid the impact of lower rates. But you can do more than reminisce over coffee about the good old days of 2% cash yields.
Take this time to revisit your cash strategy. Look for opportunities to improve yield, but also verify that you have the liquidity you need. Liquidity, in uncertain times, can be as valuable as yield.