CDs vs Installment Savings Accounts
Installment savings accounts have received some good buzz recently in the news and on financial blogs. With an installment savings account a depositor contractually commits to a bank to make monthly payments to a savings accounts for a set period of time. The bank offering the installment savings account typically pays a higher rate of interest on this type of account than some of their other deposit accounts. In fact, several banks across the country are offering installment savings accounts with rates as high as 4% or 5%. But are these accounts a good deal compared to CDs? Let's examine.
It is pretty easy to compare rates and determine that 4.5% is higher than 3.5%, right? Even a five-year child could probably make that decision for you. But, you have to look close at your savings situation before deciding that an installment savings account is a better option than a CD strcitly because of the higher rate. For instance, if you had $20,000 to invest in a 4.5% two year installment savings account or a 3.5% two year CD you will come out ahead by investing in the CD. Why? Clearly with a CD you start earning interest immediately on the full $20,000 as soon as you open the account, whereas with an installment savings account you only earn interest on the portion transferred to the installment savings account. Installment savings account act like the exact opposite of a credit card. Instead of making payments each month to reduce a balance, you are making payments each month to increase a balance. Similar to a credit card, the interest only applies to the current balance. For savers who already have enough money set aside to invest, a CD will earn more interest than an installment savings account.
The penalties for early withdrawal of funds from an installment savings account are very similar to those of a CD. Either 90 days or 180 days of interest is a typical penalty that a bank will charge. Some banks will negotiate penalties if you keep your business with them, but in this area the comparision between the two account types is a wash.
Finding A Better Rate
If you buy a CD you are locking in your money for a set period of time. The same is true with an installment savings account, except that you are committing to make payments with money you either have saved or will earn. So what happens if interest rates go higher as many economists expect? With a CD you can take a penalty and reinvest at the higher rate or just wait until the CD matures. Not so bad. But, with an installment savings account you are stuck with a contractual obligation to make payments up until the end of the term of the account. How will you feel if your installment savings account is at 3.5%, but current savings or money market rates jump higher than 5%? Chances are you will feel like you are stuck in a bad deal.
Installment savings accounts are great way for undisciplined savers to reach a savings goal. But for savers who want to maximize their return and flexibility, CDs may be a better alternative. Closely examine your financial condition before signing an installment savings account contract. It's not all about the rate!