- Though savings accounts and bonds are both low-risk ways to earn, they differ in their strengths and uses.
- A savings account is great for short-term, low-risk savings or to build your emergency fund. Having immediate access and FDIC insurance means your funds are available and protected.
- Bonds are best for long-term (20+ years), low-risk investing as they are more illiquid and produce steady returns that grow over time — making them great additions to a retirement investment portfolio.
What are Savings Accounts?
Offered by financial institutions, a savings account is a deposit account that lets people save money and earn interest on their funds. Savings accounts usually net a modest return due to their low-risk nature, compared to other options like stocks and real estate that carry a higher risk-reward potential. They are perfect to use for building an emergency fund and stashing cash for your short-term plans.
Benefits of Savings Accounts
Savings accounts are one of the safest places to store your money because of FDIC insurance, which ensures that you won’t lose your money. The Federal Deposit Insurance Corporation or FDIC, insures accounts up to $250,000. Basically, the FDIC acts as a safety net. In the worst case scenario of a bank failing, customers will still have access to their money. The recent bank failures of March 2023 were abated because of the FDIC.
Note that if you bank with a credit union, you receive the same $250,000 protection from the National Credit Union Administration (NCUA).
Earn Interest Risk-Free
You can earn interest on your holdings with little risk. With the high-interest rates of 2023, your returns add up, compounding faster than in the recent past. Usually, when the Federal Reserve raises rates, savings accounts offer higher returns, though the reverse is also true. As of May 2023, these online banks regularly have some of the more competitive APY rates.
- Marcus by Goldman Sachs – 3.9% APY
- Apple Card Savings Account – 4.15% APY
- First Foundation – 4.85% APY
- Wealthfront – 4.55% APY
- Ally Bank – 3.75% APY
These accounts are quite liquid, meaning that you can move or withdraw money quickly and easily. This makes them great for an emergency fund, where you may need money as soon as possible.
When the Fed kept interest rates near zero, savings accounts offered very low returns compared to other investment options, like the stock market. According to Deposit Accounts, in 2019, the average savings account from an online bank yielded 1.69% while that of a regular bank was 0.28%.
Savings accounts may not keep up with the pace of inflation. That means you may end up earning a negative return on your funds as the purchasing power of the dollar falls. After the Great Recession of 2008, the Fed kept interest rates near zero which meant that inflation outpaced the interest from a savings account for several years.
Some banks are sneaky and charge fees for maintaining your account, overdrafts, or exceeding a set number of withdrawals per month (usually 6), which eat into your deposits and returns.
Under Regulation D, the federal government limits the number of withdrawals from your account to only six per month before extra fees kick in. Banks also limit the number of transactions to prevent fraud, maintain liquidity, and to manage their operations and keep costs low. Though these fees were paused during 2020-21, banks have restored them.
If you need more frequent access, then a checking account is the better option.
High Yield Savings Accounts
If you take away one thing from this article, it’s to use a high-yield savings account whenever possible, or else you leave free money on the table.
Big banks like Chase or Bank of America offer traditional savings accounts with low-interest rates like 0.01 to 0.25% APY (annual percentage yield) — earning you pennies on your savings. To get over 15x those rates, open up a high-yield savings account (HYSA) with a credit union or online bank.
A HYSA is a savings account that gives a higher interest rate than a traditional savings account. Banks use HYSAs to attract new customers and their deposits, so they can offer them other, more profitable financial services. Plus, they come with the same protections as any other account, if the bank is FDIC insured.
Where does all this interest come from? The dirty little secret is that all banks make interest in similar ways, such as:
- interest on loans
- bank fees
- returns from bonds, stocks, or other assets
- bank-to-bank loans
All banks use your savings the same way, but they only pass on a sliver of the returns. Because online banks have no physical branches and operate at a fraction of the cost, they pass on more of the returns to you!
The HYSA’s main benefit of the high-interest rate is that the interest earned meaningfully compounds over time and allows your savings to grow faster. Because interest rates can vary widely, you should compare rates between different financial institutions. Plus, a HYSA comes with the same protections as a regular account, if a bank or credit union is FDIC-insured.
In the past, I’ve used online banks such as Ally Bank, Marcus by Goldman Sachs, and First Foundation for HYSAs and had great experiences using each of them. Currently, First Foundation offers the highest rate of ~4.85% APY, but other options pay over 5%.
That said, it’s important to do your research into a bank and its financial position before moving your money.
What the Hell are Bonds?
Investors can loan money to entities like the government or companies through bonds. A bond represents a share of debt, like how a stock represents a share of ownership.
With a bond, the borrower pays back the principal (amount borrowed) and interest over the bond’s lifespan, or time to maturity. The bond’s interest rate (coupon rate) is a fixed rate for the bond’s life. Bonds have less risk than stocks but also have lower potential returns.
Key aspects to consider for a bond are:
- Bond issuers – the government, company, or city that issued a bond to borrow money from investors and promises to return the principal and pay interest
- Coupon rate – fixed interest rate paid by the bond issuer in regular installments
- Principal – the face value of a bond, or initial amount of money invested and that is returned to the bondholder at maturity
- Bond grade – a credit score for a bond based on the issuer’s creditworthiness, indicating the bond issuer’s risk of default — a higher rating means less risk and a lower coupon rate
- Bond issuers – the government, company, or city that issued a bond
- Time to maturity date – the amount of time until the principal must be repaid
- Corporate bonds – Issued by companies, they typically offer a higher rate of return than government bonds, but have a higher risk of default (if the company fails).
- Government bonds – Issued by federal government departments like the U.S. Treasury, federal government bonds are seen as the safest type of savings bond, as the risk of default is very low.
- Municipal bonds (Munis) – Issued by states and cities, these bonds are used to finance public projects and infrastructure, such as bridges, schools, and highways.
- Zero-Coupon bonds – As they do not pay interest, these are issued at a discount to their face value, with an investor receiving the face value when the bond matures.
- High Yield bonds – Also known as junk bonds, high yield bonds are issued by firms with low credit ratings. So they offer a high return rate but come with a bigger default risk. Junk bonds are why investors don’t buy a bond based only on a high interest rate.
You can buy and sell bonds on the secondary market through a brokerage like Fidelity or E*Trade. You can manage your federal bonds on treasurydirect.gov or buy and sell munis from the websites of your state and local governments.
The Good Stuff
There are several benefits to holding bonds, such as:
- Steady Income – The periodic interest payments create a stable income source.
- Preserving Capital vs Growth – Because they have lower risk than stocks, they are great for those who focus more on preserving their wealth, rather than seeking higher returns.
- Diversification – Holding a mix of stocks and bonds allows you to diversify your portfolio and reduce overall risk.
The Not-So-Good Stuff
Some of the cons include:
- Interest rate risk – As interest rates rise, the value of existing bonds can fall as newer ones will offer higher rates.
- Credit risk – A baseline level of risk that the bond issuer could default. The better the bond issuer’s rating, the less likely this is.
- Call risk – Some bonds are callable, which means the bond issuer can pay off the bond early, leading to less interest and lower returns.
- Inflation risk – If inflation rises faster than the return on a bond, then the investor’s purchasing power falls as the bond reaches maturity.
- Lower Returns – Because bonds are lower risk, they return less than stocks, but its a tradeoff for low-risk investments.
Taxes… Unexpected Benefit
There’s good news with taxes, said no one ever. Most types of bonds are taxed the same, except for those issued by the federal government (aka “treasuries”) such as:
- Series I (I-bonds) – include an inflation-based variable rate and a fixed interest rate, so you earn more than inflation. I bonds cannot be traded on a market.
- Series EE – long-term savings bonds that can be redeemed for their face value and accumulated interest.
- Treasury Bills (T-bills) – short-term loans with a timespan of one year or less and sold below face value, with the difference paid at maturity. Does not pay interest.
- Treasury Notes – medium-term loans with timespans of two to ten years, paying interest every six months until maturity.
- TIPS (Treasury Inflation-Protected Securities) – securities with a fixed interest rate and inflation-adjusted principal value, providing known interest payments and inflation protection. While similar to I-bonds, TIPS can be bought or sold on public markets.
With these types of bonds, you would only pay federal income tax, as the bond’s interest income is not subject to state and local taxes. Unlike savings bonds, the interest on a savings account is subject to federal, state, and local taxes when its earned.
Depending on your income and state, you can skip out on high state taxes if you choose federal bonds over a savings account. Some states have unique tax benefits for their bonds too!
Bonds are useful to those with a long time horizon (i.e. several years) and who desire steady income. It’s best to consider the key aspects mentioned above, before adding it to your investment portfolio.
Bonds vs Savings Account — Which is Best for You?
Both are great to use and can be helpful, but it boils down to your:
- Time horizon
- Risk tolerance
- Financial goals
Generally, bonds are ideal savings vehicles for low-risk, long-term investing. They produce the best returns over periods of 20-30 years. While savings accounts are best for short-term savings needs of 1-5+ years.
In this writer’s humble opinion, it’s better to use a savings account or HYSA first, because:
- You have immediate access to your money. There’s no lockup period or penalty for early withdrawal like with bonds.
- Using an FDIC-insured bank (or NCUA-backed credit union) protects you against financial loss in a crisis — perfect for those with low-risk tolerance. However, bonds have varying levels of risk, which depend on the bond issuer’s creditworthiness as judged by credit rating agencies and the rates set by the Federal Reserve.
- Regular savings accounts are easier to open and use, especially if you have an online bank with a mobile app. In comparison, bonds are complex assets that take time to understand, research, and manage.
- HYSAs can offer higher, more predictable returns than bonds. Bond prices and returns vary based on markets, making them less stable.
- For instance, some savings bonds, such as I bonds, adjust their interest rate every six months. Over the last year, the rate on I bonds declined from 9.6% to 4.3% APY (as of May 2023).
The Bottom Line
Savings accounts are the first stop in your personal finance journey and can offer comparable yields to bonds but with no market risk. They are best for short-term plans and to maintain convenient, fast access to your cash. Investing in bonds is a longer-term endeavor as they produce superior returns over several decades, in a slow and steady way.
Using both tools in the right savings strategy that works for you can help you create financial security today and achieve financial freedom tomorrow.