There is no time like the present to begin saving. Whether you are building your emergency fund or squirreling away money for something fun like a vacation, you want to put your money in the best account possible. To get you started, here are answers to some of the most common savings questions.
1. How much should I be saving?
There is no magic number when it comes to savings. Ten percent is a typical amount to save, but it is by no means set in stone. Instead of relying on a preset number, consider the following:
- What are your savings goals?
- Do you have a timeline to meet those goals?
- Is your job stable? How long would you need to find a new one if you're laid off?
- Are you expecting a major event such as college or a wedding?
Ideally, all households should have an emergency fund of at least three to six months worth of expenses. In addition, saving for retirement is a must -- don't assume you'll be able to live off Social Security! Beyond that, you'll want to be sure you have cash on hand to pay your insurance deductibles. Once you have the essentials covered, any additional savings you accrue can be used to build wealth or save for future major purchases.
2. What savings accounts should I have?
Everyone should have at least two savings accounts: one for retirement and one of emergencies.
Retirement savings is best placed in a 401(k), IRA or similar account. These accounts are specifically intended for retirement savings and subject to special tax incentives. However, money in these accounts is also locked-in for the long haul. If you decide to withdraw money early, not only will the money be taxable, you could get hit with a sizable penalty if you are younger than 59 1/2.
Instead, you need to have a separate savings account available for emergencies and short-term savings goals. Money market accounts, CDs and yes, even your run-of-the-mill savings account will suffice. Money is these accounts is more liquid and easier to tap into should the need arise.
3. What is the difference between a savings account, money market account and CD?
A savings account is a deposit account offered by a bank, credit union or other financial institution. In exchange for your money, the institution pays a small amount of interest. Other than an interest-bearing checking account, savings accounts are the most flexible place to stash your money. You can access your funds at any time, although the Federal Reserve limits certain withdrawals such as those done by computer or over the phone to six per month per account. Since even the best savings account doesn't rack up much interest, this option is best if you are looking for a place for your emergency funds or short-term savings.
A money market account is another form of savings account. They may also be called a money market demand account or a money market deposit account. While money market accounts offer a more competitive interest rate than that available through a regular savings account, you are generally limited to five withdrawals per month. In addition, you may need to maintain a minimum balance in the account of $500 or more to avoid a penalty.
Of these three investment options, certificates of deposit (CDs) generally offer the highest rates. However, CDs are more restrictive when it comes to being able to access your money. When you open a CD, you agree to leave the funds with the financial institution for a specified term, and the institution agrees to give you a fixed interest rate in return. CD terms can typically last anywhere from one month to five years. Generally, the longer the term, the higher the interest earned.
3. What is the difference between APY and APR?
If you have spent much time around banks, you have likely run across the terms APY and APR. The APR is the annual percentage rate while the APY is an account's annual percentage yield.
What's the difference? Well, the APY takes into consideration compound interest -- that is, the interest earned on previous interest that boosts the effective yield from the principal over time. Generally speaking, banks will quote APR when they want you to borrow on a mortgage or credit card, since a lower figure will be more appealing in that scenario, and APY when they want you to deposit, when a higher figure will look more attractive.
The key here is to note the difference between the two so you don't confuse them in comparisons.
4. Which type of account is right for me?
Like the first question, the only one who can definitively answer this is you. The right type of account will depend on your financial goals. If you are setting aside money to build a deck this summer, a savings account may just do the trick. If you are trying to earn extra interest on your emergency fund, putting some of it in a CD ladder may be the right choice. Just be sure you leave enough out in other funds to give quick access to some of your cash should the need arise.
Starting a new savings effort can raise a lot of questions, but gaining some extra cushion in your finances should be worth the trouble of answering them. Plus, once you know the answers to these basics, you can share them with friends and family who'd like to improve their finances too.