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Zero Percent Interest on my Savings! Why Can’t Tom Do Better?

By JLP | November 11, 2010

This is a guest post by Doug Warshauer, author of If I’m So Smart Where Did All My Money Go: Balancing Your Financial Objectives for Lasting Wealth (Personal Finance)*. I met Doug through Twitter. Gotta love social networking.

My friend Tom plans to buy a car in two years. His current car, a 2003 Chrysler, is nearing the end of the line. Tom recently began setting aside some money each month, hoping that, two years from now, he’ll have enough accumulated to purchase his new vehicle. The car he has his eye on: a Honda Accord, which he estimates will cost him about $27,000.

Tom, and millions of other people in similar situations, face a dilemma right now: how to invest that money which they plan to spend in a couple of years. He realizes that two years is far too short a window of time to invest in stocks. When the stock market falls – as it has numerous times in the past decade – the losses could wipe out a substantial portion of his savings and delay his ability to buy the car.

Unfortunately, with short-term interest rates near zero, Tom finds all the investment options unappealing. Bank savings accounts, 2-year CDs, Treasury bills, and money market funds all offer negligible returns. With such undesirable options, he feels tempted to find some alternative investment vehicle.

What should Tom do? Here is my suggestion:

First, he needs a little perspective. While nominal short-term interest rates are at an all time low, real interest rates (inflation-adjusted) are not too different from historical norms. Tom is not going to get much of a return on his investment, but the cost of the car is also not likely to rise much, either.

His ability to buy the car in two years depends on two factors: 1) saving enough money each month, and 2) not losing the money he saves through poor investing.

How can he keep from losing it through poor investing? The biggest risk we’ve already mentioned: he must avoid the temptation to invest in the stock market. Still, even if Tom sticks to fixed income investments, he needs to avoid the temptation to accept two other risks that could undermine his ability to buy that car.

First, he needs to protect against credit risk, the risk that the security he buys will fall in value if the likelihood that its underlying investments default. Tom can essentially eliminate credit risk by purchasing U.S. Treasuries, putting his money in a bank that offers an FDIC guarantee, or investing in a bond fund that buys highly rated securities. While mutual funds that buy high-yielding (lower rated) bonds might offer tempting interest rates, they could fall sharply in a down market, when the risk of default of lower-rated bonds skyrockets.

Second, he needs to protect against interest rate risk, the risk that the security he buys will fall in value if interest rates rise. He can eliminate most interest rate risk by purchasing securities with a short duration. Savings accounts, money market funds, and short-term bond funds all fit this description.

As with credit risk, Tom may be tempted to accept some interest rate risk in order to earn a higher yield. Currently, a 2-year Treasury yields about 0.5%, and a 30-year Treasury bond yields about 4.25%. After all, with a highly liquid market for Treasuries, he’ll be able to sell the 30-year bond when he wishes to buy the car.

If he buys the 30-year bond, and interest rates rise, he could be in for a shock in two years. An increase in long term interest rates of two or three percent could wipe out 25% or more of the value of his investment! Once again, the downside of chasing a higher return dwarfs the modest benefit.

True, to avoid credit risk and interest rate risk, Tom must resign himself to accepting the negligible returns he will earn investing in high-quality, short-term fixed income investments. But accepting them comes with a real reward: the near certainty that two years from now, as long as he saves as much as he intends, he will be the owner of a new Accord.

What would you do? Would you be tempted to seek a higher-yielding investment?

Doug Warshauer’s new book, If I’m So Smart Where Did All My Money Go: Balancing Your Financial Objectives for Lasting Wealth (Personal Finance)*, teaches how people can design savings and investment plans to meet all their financial objectives. He blogs on personal finance issues at www.dougwarshauer.com.

Topics: Books, Budgeting | 13 Comments »


13 Responses to “Zero Percent Interest on my Savings! Why Can’t Tom Do Better?”

  1. Jack Says:
    November 11th, 2010 at 9:58 am

    Good Lord, man! My NEW car is a 2000 Ford.

  2. Nick Says:
    November 11th, 2010 at 9:59 am

    I am actually currently doing this with short-term money. I buy Ally Bank 5-year CDs. They’re currently paying 2.49% APY and have only a 60-day early termination penalty. So even if (when) you pull your money out early, your rate is still significantly higher than a 2-year CD.

  3. BG Says:
    November 11th, 2010 at 10:00 am

    I’d purchase the car on credit today. He can get a 3.9% rate on a new car loan if his credit score is good.

    I’m normally adverse to debt, but seriously, how low do rates need to go before you bite? If you wait the two years, car prices just might go up: not from an inflation perspective, but in regards to manufacturer rebates and an increase in demand for new cars as the economy picks up.

  4. Beeg Says:
    November 11th, 2010 at 10:30 am

    I disagree with BG. Since car loans usually are NOT tax deductable, the cost to the consumer is AFTER tax interest. Usually for financial returns we compare BEFORE tax rates.

    So, the cost to Tom isn’t 3.9%, it is 3.9% after tax, which (on 25% tax bracket) is 5.2% interest. Has anyone been able to find over 5% ROI right now? Seems to me to save this 5% if you have no other options.

    Now, if he can better invest his money into real estate, a side business, gold, other commodities or Asian stocks – maybe he should get the loan thinking he can beat a 5% hurdle rate.

    Either way $27,000 sounds like a lot of money for Tom to spend for a car. I think TOm should look for a cheaper one (2-3 yr old with several miles on them).

  5. BG Says:
    November 11th, 2010 at 10:46 am

    Beeg) I agree, buying a new car isn’t for everyone. But if Tom can save enough to purchase a car in cash after 2 years of savings. He certainly can purchase the car on credit @ 3.9% and pay it off over those two years.

    The interest would cost him about $70 month ($1700 total interest).

    Just putting the options out there: If he is able to get manufacturer rebates of $5k (as an example) — I wouldn’t risk losing today’s rebates to save $2k in interest. The rebates may not be there in 2 years…

  6. Travis Says:
    November 11th, 2010 at 11:09 am

    Here are 3 good cash alternatives that I have been using (outside of short-term US govt bonds):

    Option 1: short-term US corporate bond fund
    current yield: 3%
    year-to-date return: 6.60%

    Option 2: floating rate bank loan bond fund
    current yield: 4%
    year-to-date return: 7%

    Option 3: high-quality, low risk international bond fund
    current yield: 4%
    year-to-date return: 11.4%

    All three also have little or no interest rate risk for when interest rates start to rise.

  7. Brad Says:
    November 12th, 2010 at 12:28 pm

    What about a high-interst checking account? If you’re willing to jump through the hoops of making a few transactions each month and having your paycheck deposited into it, most banks and credit unions in my area are above 4% interest (up to $25K). Not bad for a short-term investment like that.

  8. Don Says:
    November 15th, 2010 at 12:12 am

    @Travis: Obviously those funds you are in have interest rate risk. If they went up way more than their yield on a year-to-date basis, that had to come from somewhere and it could disappear to exactly the same place.

  9. Travis Says:
    November 15th, 2010 at 9:12 am

    Don,

    Bank loans reset daily and carry ZERO interest rate risk.

    International bonds have far less interest rate than US government bonds for obvious reasons. Besides, the fund I mentioned has a duration of only 3.3 years (that’s less than the yield, so it would take an enormous hike to post a negative return – very unlikely).

    The short-term corporate bond fund I mentioned has a duration of only 1.9 years, which is also less than its 3% yield. This too makes it very unlikely to get punished with an interest rate hike. Returns would be lower, but they would still be positive (and better than those of money markets).

  10. Jack Says:
    November 15th, 2010 at 8:06 pm

    My 1995 Toyota just hit 200,000 miles today.
    (The “new” vehicle, a 2000 Ford, has 157,000 miles.)

  11. LA Says:
    November 16th, 2010 at 1:43 pm

    @Travis – where do I find the funds you are mentioning so I can see if they would work for me?

  12. Travis Says:
    November 17th, 2010 at 9:33 am

    My two favorite floating-rate funds are LFRAX and FFRHX.

    My favorite international bond fund is TPINX.

    My favorite short-term US corporate bond fund is LALDX.

    Go check ‘em out on yahoo, then visit their website for a fact sheet and prospectus.

    If you want an ETF instead, CSJ is a good one for short-term corporate bonds.

  13. Debt Free Daniel Says:
    November 20th, 2010 at 8:09 pm

    We know the rules of the game, the higher the returns, the higher and the risk. Thus investing your money intended for your car purchase is not a good idea unless you are saving money less than what is supposed to be saved. In my case, I will deposit my money to a special bank account intended for that purchase, when half of the amount is deposited, will talk with the bank if I can get a special loan and be paid through that special bank account made.

    Daniel
    thedebtsolutionsystem.com/financial_resources_kit/tdss_squeeze/opt.html

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