Unless you’ve been living under a rock for the last few years, you’ve noticed that short-term interest rates have hit a floor. This is wonderful news for the borrower. If you’re buying a new home or car, interest rates haven’t been this low in decades.
Savers and investors haven’t been so lucky, however. With short-term investment options offering the lowest returns in a generation or more, it’s difficult to grow your cash.
Short-term investment options refer to money you would like to grow and compound but will need within two to five years. Today, “short-term investment options” might even be considered an oxymoron because investing typically refers to purchasing a financial asset, like a stock or bond, with the expectation that it will provide income and appreciate in value.
Finding higher-return, short-term investment options can be a challenge. Read on to learn about short-term investment options, ordered from most conservative to least conservative.
When Do You Need Short-Term Investment Options?
Since long-term investing in the financial markets offers greater returns, why would the investor need short-term investment options? Maybe you’re saving money for the down payment on a house you plan to buy in four years. If you put those funds in the risky stock market, they are subject to fluctuating returns.
In spite of the U.S. stock market’s historical average annual returns of nearly 9 percent according to Barclay’s aggregate statistics, that rosy long-term return masks the fluctuating annual returns. How would you feel watching your future home’s down payment, invested in a U.S. stock market fund, lose 20 percent of its value in one year?
Another example is if your son, Junior, is heading to college in three years. Putting his tuition payments in equities would be a bad idea. You need to keep his college funds in short-term investment options. Money you need in the next two to five years needs to be in short-term investments.
Read: Warren Buffett Reveals His No. 1 Investment Strategy That Anyone Can Follow
What Are the 7 Best Short-Term Investment Options?
1. Online Bank Savings and Money Market Savings Accounts
Money held in a bank or credit union is insured up to $250,000 according to their respective governing bodies, the Federal Deposit Insurance Corporation for banks and the National Credit Union Share Insurance Fund for credit unions. Savings and money market deposit accounts allow the customer to save money and withdraw all funds at any time without penalty. In exchange for this liquidity, the accounts pay interest, normally at a lower rate than some of the other short-term investment options.
This option is great for Olivia, for example, who wants to know that her $2,000 will be available next July to pay for her vacation to Hawaii. She doesn’t really care if she gets much growth on this money. Olivia’s main concern is that when the vacation bill arrives, she has immediate access to the cash, but she was savvy enough to shop for the highest rate before opening an MMDA.
Related: Review: 10 Best Savings Accounts of 2015
2. Brokerage Money Market Mutual Funds
Although bank and brokerage money market accounts sound the same, there’s a slight difference. A money market mutual fund is a low-risk mutual fund. It invests in short-term government securities, commercial paper and other short-term securities. Although MMFs traditionally hold their value at a share price of $1.00, there is no guarantee that the principal value won’t deviate from $1.00, which makes the MMF a bit riskier than the comparable bank and brokerage account products.
Cameron, for example, already has an investment brokerage account through which he invests in stock and bond mutual funds. He decides to keep his short-term investment options in an MMF. He’s going to buy a car in three years and wants the cash available at that time.
Cameron’s not worried about the possibility of losing principal because it’s highly unlikely that the value of his MMF will deviate from $1.00. He also appreciates the fact that he can get a slightly higher yield than he would receive in an MMDA.
3. Certificates of Deposit
A certificate of deposit (CD) is a time deposit account issued by banks and credit unions that works similar to a promissory note. In exchange for a competitive fixed interest rate, the depositor is required to keep his money in the account for a specified amount of time.
CD term lengths range from a few months to five or more years. An account holder is not allowed to withdraw from the CD until the maturity date. Any premature withdrawal is subject to a significant penalty fee.
CDs can be purchased online or at brick-and-mortar banks and investment brokerage companies. They are normally insured under the same conditions as bank and credit union savings products. The upside is that, because you’re committing to leaving your money with the institution for a longer period of time, you qualify for a higher rate of interest. The downside is that, if you decide you need the money before the maturity date of the CD, you’ll pay a penalty. In general, the saver sacrifices an early withdrawal penalty of three to six months’ interest if he takes the money out too soon.
Cherise, for example, saw a great one-year CD rate online. She’s saving up to pay for her wedding but wants to earn a bit more interest than she’d get in her online MMDA. She was certain she could leave the money in the CD for the full 12 months, so she opened a CD at an online bank with a great promotional rate.
Even if you have to withdraw the money early, it’s occasionally still a good idea to invest in a CD. In some cases, the interest penalty isn’t enough to offset the higher overall rate of return of the investment.
4. Treasury Inflation Protected Securities (TIPS)
TIPS are marketable securities whose principal is adjusted by changes in the Consumer Price Index, according to TreasuryDirect.gov. TIPS pay interest every six months and are issued with maturities of five, 10 and 30 years. These investments have been maligned in the past because the low interest rate climate thwarted their returns. But, inflation will not likely remain this low in the future. And when inflation picks up, TIPS can shine.
Jonathan, for example, is a savvy investor who is expecting inflation to rise during the next few years. He expects to retire within the upcoming five years and wants to keep a chunk of cash liquid for this next stage in life.
For part of his short-term cash, he’s opened up an account with TreasuryDirect and put a portion of his short-term cash in TIPS. Jonathan is confident that when inflation starts to rise again, he won’t lose the purchasing power of his hard-earned cash.
5. I Savings Bonds
The I bond, another government-sponsored product, protects your cash from inflation. This investment has two return components. The first is a fixed interest rate set at issue. The second interest rate is based on the inflation rate and usually changes twice a year. An additional benefit of the I bond is that interest payments are free of state and local tax and, in some cases, completely tax free, such as when the investor is paying qualified educational expenses.
Although recommended for several savings needs — including by Zvi Bodie, author of “Risk Less and Prosper” as well as co-author of several finance and investing textbooks — I bonds come with several investment caveats. An I bond can be a great investment for those without a lot of cash because the minimum investment starts at just $25. An I bond must be held for a minimum of one year before withdrawal, so it is not a good option for the ultra-short-term saver.
If you cash in an I bond before five years have passed, you’ll sacrifice three months of interest. Further, investors are limited to $10,000 in purchases per year with an additional $5,000 allowed if purchased with a tax refund.
Take Jamal, for example. He is a highly compensated engineer who invests the maximum $10,000 and $5,000 of his tax refund in I bonds every year. He understands that his I bonds will earn interest for up to 30 years, and the penalty for withdrawal after one year is slight. He considers the money saved in I bonds as his emergency cash fund.
Read: 5 Ways to Build an Emergency Fund in 5 Months
6. Short-Term Bond Funds
A short-term bond fund is a mutual fund that invests in bonds with maturities of just a few years. The type of bond in the fund can vary; examples include government, corporate, taxable and tax-exempt bonds. This bond fund is the riskiest of short-term investments discussed so far.
When you invest in a short-term bond fund, there is a possibility that you might lose some of your initial investment or principal. Unlike a CD or money market savings account, your initial investment value can fluctuate.
If you anticipate that rates will rise soon, then you might be better off with a different short-term investment because when interest rates rise, the value of a bond or bond fund will decline. With a short-term bond fund, the decline in principal value will be lower than with a longer-term bond fund, however.
Juanita, for example, is planning a large remodel of her 1950s ranch-style home in five years. She decided to reach for a slightly higher yield by investing in Vanguard’s Short-Term Bond Index Fund. This broadly diversified index mutual fund will give Juanita exposure to U.S. investment-grade corporate and government bonds with maturities from one to five years. She’s read the prospectus and is aware that there is a possibility that the principal value of the investment might decrease but likely only by a small amount, so she is comfortable with the investment.
7. Individual Short-Term Bonds
The risk-averse individual with more than $5,000 might consider investing in individual short-term bonds. In general, an individual bond must be purchased in increments of $1,000 to $5,000 or more. Unlike a bond fund, if you buy an individual bond, you lack diversification.
The benefit of buying an individual bond versus a fund is that if the bond is held to maturity, then you’re assured of receiving par value, which is usually $1,000. Individual bonds, which are riskier than the previous investments listed in this article, usually pay a higher return. The risk is that if the issuer defaults, then you won’t get your full investment back.
Take Sarah, for example, who has a good, steady job. She is in a high tax bracket and wants to reach for a higher yield for her short-term cash than she can get with a CD. She doesn’t have any immediate needs coming up for the money but wants to keep it accessible just in case. She could take $10,000 and invest it in several tax-free municipal bonds, which she could buy through her discount brokerage account.
Read: How to Profit Off Today’s Rising Interest Rates
Whether you are an aggressive or conservative investor, you need to consider keeping a portion of your money in short-term investments. Realize that reaching for higher yield correlates with assuming greater risk. To determine your best short-term investment options, figure out how much money you need in short-term investments and then allocate your capital in line with the amount of risk you’re willing to take on. Whichever options you choose, make sure you’re aware of the highest yields available for your particular investment selections.
This article originally appeared on GOBankingRates.com: 7 Best Short-Term Investment Options
This article by Barbara Friedberg first appeared on GoBankingRates.com and was distributed by the Personal Finance Syndication Network.
No comments:
Post a Comment