Where Should You Keep the Money You're Saving for a Car?

Hint: It's got to be someplace where your principal is protected.

Whether you're buying your first car or your fifth, you're probably aware that even if your plan is to finance that vehicle, you'll need money for a down payment. Or, if you don't want to deal with monthly auto loan payments, your goal may be to purchase a car outright.

Saving up for a car can take time, so it's important to find a good home for your money while you're working toward your goal. And for the most part, a savings account is really your best bet.

Stick to a savings account

The money in your savings account likely earns some interest -- but it may not earn a lot. This especially applies in today's interest rate environment. On the other hand, if you were to put your car funds into a brokerage account and invest that money, you'd have a chance to earn a much larger return on it.

But tempting as that may be, savings accounts offer one big advantage over brokerage accounts, and it's that your money is protected for up to $250,000 per person as long as your bank is FDIC-insured. That guarantee alone is worth forgoing a higher return on your money.

As a general rule, it's not a great idea to invest money you expect to need soon. That's because the stock market can be very volatile, and if you don't give yourself enough time to ride out downturns, you could end up with losses.

Let's say you have $8,000 on hand and your goal is to save up $10,000 and buy your car by the end of the year. If you were to put your $8,000 into a brokerage account, by November, your portfolio value could shrink to $6,500 if stock values fall. And that's not a great thing if you want to buy your car in December. On the other hand, if you stick $8,000 into a savings account today and don't touch it, you'll have that $8,000 at the end of the year, plus a touch extra in accrued interest.

What about CDs?

Certificates of deposit (CDs) tend to offer higher interest rates than savings accounts do, so you may be tempted to keep your car funds in one. But right now, that doesn't make much sense. CDs aren't paying much more than savings accounts these days, so for that minimal boost in interest, it's not worth having to lock yourself into a preset CD term.

If you end up having to cash out a CD early, you'll generally be penalized to the tune of several months of interest. And while that's not a huge loss with today's lower interest rates, it's also a situation not worth putting yourself in.

Saving for a car takes effort. While you may be inclined to invest your car funds to reach your savings goal sooner, there's a lot of risk in going that route. You're better off keeping that money in a traditional savings account and doing your best to keep adding to it until you have enough to drive off with the vehicle of your choice.