I’ve frequently said to “do the math” and this guest post just helps drive home this point -
When you’re figuring out where to put your money, you have to do a lot of math and planning. The planning part is to help you figure out how to amortize your finances throughout your life, and the math part is to make sure you get the best possible return on your investment.
Today we’re going to look at online savings accounts, but first I want to focus just a bit on these two questions of math and planning, so you understand where I’m coming from.
How much money do you have, and when are you going to need it?
This is always the first set of questions you need to ask yourself before you put your money into any type of savings vehicle, from an online savings account to a Roth IRA. How much money do you have right now? Do you plan to earn more money that can be saved (vs. money that must be spent right away) in the future? Do you expect your earnings to grow over time, or do you expect your earnings to decrease soon? (A young person starting a career might expect earnings to grow; a couple planning a family might expect earnings to decrease if one partner quits a job to take care of the baby.)
When are you going to need your money? Are you planning to buy a house? Move to another state? Do you anticipate becoming the primary caretaker of young children or aging relatives? Do you want to go back to school?
Before you can start thinking about how to save and invest your money, you have to take some time to answer all of these questions.
Understanding money math
Once you’ve taken a look at the planning question, it’s time to start understanding all of the mathematical terms involved in saving money. Do you know what APY means, for example, and how to calculate it? Do you know whether a given interest rate is calculated daily, monthly, or yearly? Do you know how to effectively calculate the risk of any given investment?
If you’re not up on your money math, it’s time to take a refresher course. Joe Taxpayer has many great articles on how to calculate the true value of investments, savings accounts, and financial opportunities. Take some time to read through this site, and learn how to apply Joe’s tips to every new financial offer you encounter.
Online savings accounts: a good mathematical solution for short-term savings
There are a lot of solid, fixed-rate investments out there, including certificates of deposit (aka “CDs”) and goverment-backed Treasury bonds (not to be confused with Treasury bills — and read this if you want to learn all of the math behind Treasury securities).
However, one of the most solid investments out there, especially for new savers, is the good old-fashioned savings account. Compound interest is one of the first lessons we learn, financially, and it still applies. An online savings account is even better than a brick-and-mortar savings account because the money saved on overhead goes back to you. Online savings rates by Discover Bank, for example, are at 0.80% APY as of November 14. That means that if you put an initial $1,000 in the account, then add $200 every month, by the end of the year you’ll have $3,418.39 including interest.
Why are online savings accounts good mathematical solutions for short-term savings? Because any gains made by putting your money into a higher fixed-rate investment, such as a CD, are wiped out if you have to pull that money out early. Remember the questions we looked at earlier regarding when you think you’ll need your savings. If you put all of your money into a 24-month CD, and then you decide to get married/buy a house/have a baby, you have some problems to solve.
If you’re thinking short-term, the online savings account with a high interest rate is the way to go. Or, if you’re thinking medium- to long-term, combining an online savings account with some longer-term investments is a great way to have money when you need it as well as plan for the future.
If nothing else, your money should at least rest in an online savings account before you transfer it to your Roth IRA or 529 College Savings Plan. Every day you have extra money is a day it needs to be earning interest for you — and online savings accounts are set up to help you make that happen.
In conclusion: the next time you come into some savings, start thinking about math and planning. If you plan on spending your money soon, put it in an online savings account; if not, use what you know about money math to find the best possible long-term investment.