Savings accounts are Mickey Mouse investments: In today's low interest environment, they pay only a very modest rate of interest. You can consider several alternative investments that pay interest as well. These may not be as safe or liquid, but they'll give your child more interest over the long run.
Here are some of the other types of investments that may pay a higher interest rate:
- Certificates of deposit
- Bank money market funds
- U.S. savings bonds
Financial Building Blocks
Other interest-bearing investments, such as Treasury bills and bonds, corporate bonds, municipal bonds, zero coupon bonds, bond mutual funds, and bond unit investment trusts exist. These investments are more sophisticated and may require a relatively large initial investment that's probably beyond your child's means. Still, as part of your child's financial vocabulary, these investments are explained in Teach Kids to Diversify Their Investments.
Piggybank on It
Your child can start saving in a savings account. Then when the balance is a $1,000 or more (or whatever's required for a CD), that money can be shifted into a CD.
Piggybank on It
Interest rates paid by banks can vary quite a lot, so shop around. The bank across the street may pay 1 percent more for the same term CD.
CDs Aren't Just Musical Recordings
Certificates of deposit (CDs) aren't only things your child plays on a stereo or computer. They're also a type of investment that works like a savings account. The CD pays compound interest, and CDs have the same FDIC insurance protection as savings accounts. The difference between a savings account and a CD, however, is making a commitment. Your child agrees to put a fixed amount of funds for a set time—for example, six months, one year, or five years—and receives a fixed amount of interest. Your child knows from the day he puts in his money what he'll have when the CD comes due.
The bad thing about CDs is that today interest rates are very modest compared with stock market returns, so the money won't grow as fast as it could with other types of investments.
CDs are called just that because a certificate is issued when the investment is made. The certificate is a statement that shows the following:
- What's being deposited. Usually certain minimum deposit requirements exist. The higher the requirement, the greater the interest that will be paid. CDs usually require a deposit of $1,000 or more.
- What rate of interest is being paid. You'll see two rates of interest quoted. One is the stated rate of interest that's being paid. For example, it may be 5 percent annual interest. The second rate quoted is the APR, or annual percentage rate. This rate takes into account the impact of compounding, so the APR will always be higher than the stated rate of interest.
- How long the money must remain in the account. This is called the term of the CD, and it's usually three months, six months, one year, or longer. Usually the term is expressed in terms of years. If it's less than a year, it may be expressed in terms of months (typically three, six, or nine months). Sometimes the term can be set at just about any date you want.
It's a simple rule to remember: The longer the CD, the higher the interest. Here's a sample of what interest rates were available at one local bank (rates change on a daily basis):
|Term of the CD||Interest Rate|
|6 months||4.10 percent|
|1 year||4.27 percent|
|2-1/5 years||4.36 percent|
|5 years||4.54 percent|
Bank Money Market Funds
Piggybank on It
Mutual fund companies also offer money market funds. These funds pay dividends, not interest, even though the funds themselves earn their money by collecting interest. Money market funds with mutual fund companies generally pay a little more than bank funds.
Banks may offer investors a special kind of savings account, called a money market fund. With a minimum investment of $1,000, $2,500, or $5,000 (depending on bank requirements), money can earn interest for any period of time the money is left in the account. There's no minimum investment period, and there's no fixed interest. Your child will know what the fund is paying on the day he goes in, but the rate floats with the prevailing interest rates and thus can go up or down. Currently, bank money market accounts are paying only between 2 percent and 3 percent annually.
Again, bank money market funds aren't for the very young saver who has only a few dollars to start with. But once a savings account has accumulated the money market fund minimum, it may be a good idea to switch some money to this type of investment.