In Part-1, I defined medium term investments and discussed their risks. The purpose of Part-2, is to learn what influences the rates of return on short and medium term investments and learn the pros and cons to each investment option.
The Federal Funds Rate
Short and medium term investments, are heavily influenced by the federal funds rate. When you hear anyone talk about interest rates rising and falling, they are typically referring to the federal funds rate.
The federal funds rate is a target rate, set by the Federal Reserve, at which one bank borrows from another bank. The goal of the Federal Reserve is to control the amount of money in the economy. With low interest rates, money becomes easily accessible. If interest rates are raised, money becomes harder to borrow and more likely to be saved.
Investing In Debt
The easiest way to view the concept of a bond is instead of owning, you’re borrowing. Unlike a stock, you’re lending your lending money for a certain period of time. To compensate you for lending money, the issuer pays interest over the period of the bond.
Bonds are issued by many different organizations including local, state, and federal governments and many different sized corporations.
In Medium Term Investments Part-1, I discussed interest rate risk. Explaining that if interest rates rise, than bond prices fall. However, that’s not entirely true for shorter-term bonds.
Example # 1 – You bought a bond issued by Company X 2 years ago for $1,000. The bond expires in 18 years and pays 3% interest a year. In the past two years, interest rates have risen and now Company X, assuming they are of equal risk today as they were two years ago, is issuing a 20 year bond for $1,000 that pays 6% interest. If you wanted to sell your bond that you bought two years ago, you have to sell at a discount for the buyer to be compensated for taking 2% less interest a year.
Example # 2 – Instead of issuing 20 year bonds, Company X is issuing 1 year bonds at 2%. If interest rates went up, the price of your bond wouldn’t change as much because they expire soon. In example 1, a buyer would have to be compensated for owning a bond that pays a below average interest rate for 18 years. Now a buyer would only need compensation for earning a below average interest rate for 1 year. Also, when your bond expires, you plan on buying a new bond each year. In example #1, the fact that interest rates went up, decreases the value of your investment. In Example #2, since you plan on reinvesting, interest rates rising are actually beneficial.
Investments for Medium-Term Goals
Many medium term investments will be composed of different short-term debt like bonds. It’s important to understand the fundamentals of bonds and interest rates, so you can make a better decision on what medium term investments work best for you.
Below, I listed a few investments from the least amount of risk/return to the greatest amounts of risk/return to look into, if you’re saving for a medium or even short term goal.
High Interest Savings Accounts
For years, I accepted a big banks less than .5% interest on my savings. I easily found an online bank, ING Direct, that paid about 8 x the amount of interest I previously received.
The average return on high interest savings accounts is low compared to other short term investments. As of right now, interest rates are fairly low, therefore banks are paying little interest.
If interest rates rise in the future, most high interest savings accounts will also raise their interest rates to stay competitive.
- Low minimums
- No or easily avoidable fees
- Low return
- Too much flexibility
The structure of an online banks, allows them to pay higher interest rates than most brick and mortar banks. Here are a few recommendations, followed by their current interest rate.
Money Market Accounts
A money market account, not to be confused with a money market mutual fund, is very close to a savings accounts. Both are issued by a bank or credit union. Both offer low rates of return and have very little risk.
The biggest difference between a money market account and a high interest savings account is the flexibility. Most money market accounts limit the number of transactions to a specified amount each month. Since the bank places restrictions on the number of transactions, they can invest the money differently than a savings account. This allows you to earn a slightly higher rate of return that a high interest savings accounts.
- Higher rate of return than savings accounts
- FDIC insured
- Less flexibility
- Higher minimums than savings accounts
The more you’re willing to invest, the higher your rate of return. Start out by researching what local banks are offering. Second, go to bankrate.com rate to see if any national banks are offering a greater rate. Choose a bank with a high rate of return, great customer service, and is FDIC insured.
Money Market Mutual Funds
Money market mutual funds and money market accounts are very similar. Instead of depositing your money to a bank, you’re making a deposit to a mutual fund manager. The money manager by law invests your savings in specific short-term debt.
Your investment does maintain most of its flexibility. Most money market mutual funds offer you a limited amount of check writing and transactions per month.
There is no guaranteed rate of return with money market mutual funds. Rates vary widely, from fund to fund.
- Historically, a higher rate of return than a savings account.
- Still have flexibility
- Money market mutual funds have expense ratios
- Higher minimums than savings accounts
- Not FDIC insured
There are many different types of money market mutual funds. Before investing in one fund, do a lot of research by reading the prospectus, reviewing the historical rates of return, investment managers, expense ratios, and looking for any other fees for opening an account.
Currently, I store my emergency fund in a money market mutual fund. I use, Vanguard’s Prime Money Market Fund.
CD’s are bought through a bank or credit union. The CD, is bought for a specific amount of time. Generally, 6 months, or 1 to 5 years.
During the investment period, there are restrictions on withdrawing the cash. Since the bank has greater control of your money for the length of your CD, they are able to pay you a higher interest rate than other investments such as high interest savings accounts.
At the time of maturity, your original principle plus interest is returned to you.
- Higher rate of return
- Locked in rate of return
- Most have money upfront
- Less flexibility in withdraw
Note: Another way you can use CD’s is through a CD ladder. They require a little more work, but if done right, can lead to a higher return. An explanation of CD ladders.
Research rates on bankrate.com from FDIC insured banks. Look for an FDIC insured bank, with a high interest product to invest in.
Short Term Investment Grade Bond Mutual Funds
If you’re able to handle a more risk, you can look to a short term investment grade bond mutual fund.
The managers of an investment grade bond fund, typically invest in debt with more risk and reward than money market accounts. Allowing you, as the investor to earn a higher rate of return.
- Highest rate of return
- Wider range of returns
- Least flexibility
- High minimums
It’s important to do your research when investing in any mutual fund. Read the prospectus before investing in your fund. The prospectus will allow you to see the goals the mutual fund manager has for the fund. This will allow you to make a better decision regarding your financial situation.
Example of Buying A House
If I were going to buy a house in a few years and wanted to save up for a down payment, here’s what I would do.
- Decide on my goal
- Calculate how much money I would need to invest on a monthly basis to reach my goal, earning 0%
- Start investing money in a high interest savings account until I have enough to purchase a short term bond mutual fund
- With the figure I calculated from step 2, set up an automatic purchase of the bond fund, like Vanguard’s Short Term Bond Fund, to take place once a month
- When my goal is one year away, start investing the monthly contribution to a high interest savings accounts
- For the final 12 months, sell a portion of the bond fund each month, and deposit the sum into the high interest savings accounts
- Find a house and use the savings for my down payment. Any amount earned through interest will go to paying more of the house or other housing expenses.
The lack of savings for medium term goals is one of the biggest problems in personal finance. There is never a better time to start saving than today.