Deciding to put your money in an interest-bearing account may seem like a no-brainer. But sometimes a no-interest checking account may be more cost-effective. Here's why.
Interest-bearing checking and savings accounts offer the lowest rates around. Sometimes banks offer to add or increase the interest on your account if you maintain a higher average balance. As tempting as this may seem, make sure the expense of maintaining the account doesn't exceed the interest paid. Even if the bank waives its fees when you keep a high average balance, there is an opportunity cost to tying up all that cash in a low-yielding account.
Say you pay $4 a month (or $48 a year) in account and ATM fees. If you earn 2 percent interest, you need to keep at least $2,400 in your account just to break even. And you'll have a hard time earning any real return on your deposits, even if you don't pay fees. That's because the interest rates you earn on a checking or savings account often don't exceed the average annual inflation rate, which was 3.1 percent from 1926 through 2000. In short, you end up losing purchasing power.
There are, however, other ways to get better returns at a bank. Instead of parking the majority of your cash in a savings account, you could open one of the bank's certificates of deposit (CD). To do so you agree not to withdraw your money for a period of time ranging from three months to five years or more. The shorter term the CD, the lower the rate you'll get.
If interest rates fall, you're in luck because the bank must give you the rate it quoted when you bought the CD. If rates climb, however, you're stuck with the rate you agreed to even though it's lower than one you could get if you bought a new CD.
You can get money out of a CD prematurely, but you'll pay a penalty -- typically three months' interest. And if you have more than $100,000, you can put it into a so-called jumbo CD that pays even higher rates. However, any amount over $100,000 isn't insured, so the excess is only as secure as the bank itself.
When opening a CD, be sure you understand whether the rate is fixed or variable, and how often the interest compounds. A CD interest rate can yield different sums of money depending on whether a rate is compounded daily, weekly, monthly, quarterly or yearly.
Banks also offer money market deposit accounts (MMDAs) that invest your money in short-term loans to government agencies and corporations. Typically, they require you to keep between $2,000 and $3,000 on deposit. Because the minimum is high, a money market account is often free, and you're likely to get free checks to write against your account's balance. However, there may be a minimum check-writing amount (usually $100 per check or more), and you may be limited to the number of checks you can write a month.
When shopping for an interest-bearing account, keep the following in mind:
Banks often review the yields they offer on a weekly or monthly basis and may lower or raise the rates just as often. That means the rate that's offered when you open your account may be dramatically different a year later, or even a month later.
Banks can quote rates that compound daily, weekly, monthly, quarterly or yearly. Over a period of 12 months, interest that compounds yearly could yield less money than a lower interest rate that compounds daily. To compare how much money you'll earn from various accounts in a year, ask for each account's "annual percentage yield" rather than for its interest rate. Banks typically quote both figures, but only APYs are calculated the same way everywhere.
To see how quickly your money will grow in an interest-bearing account, try our savings calculator.
Next: Beating fees