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Deposit accounts: Advantages and disadvantages

At a glance:

Deposit accounts were once the investment of choice for most Americans. Although many investors have sought higher returns elsewhere, deposit accounts continue to offer advantages for the modern investor.

Competition for your investment dollar has spawned a wide variety of deposit accounts that offer convenience, flexibility, and security for your money. Deposit accounts can be an integral part of your financial planning toolkit.

Types of available deposit accounts

Perhaps your first experience with money — other than spending it — was starting your first savings account at the local bank or credit union. With competing investment opportunities luring their customers, local savings institutions have developed a wider array of savings opportunities.

Passbook savings accounts — the most basic

Passbook savings accounts, named for the little physical record-keeping ledgers that are now a thing of the past and often no longer marketed as "passbook accounts," are still the type of deposit account that most people know about. These regular savings accounts are the simplest type of account to open and maintain, usually requiring minimum balances, sometimes very small, to avoid fees.

They also offer immediate accessibility for both deposits and withdrawals because of expanded hours and locations of most institutions' checking features, and ATM (automated teller machine) access. The main drawback of traditional passbook accounts is that they typically pay very low interest (for banks) or dividend (for credit union) rates.

Why some accounts pay more

Higher rates are available with special accounts that often tie the rates they pay to various fixed-market yields. These accounts also offer a high degree of liquidity. However, the higher the rates they pay, the higher the minimum balances that they typically require to avoid fees. Minimum balances for special savings accounts typically range from $2,500 to $10,000.

A man doing a banking transaction at a Citibank ATM fast cash machine. Moody's Investors Service has lowered the credit ratings on some of the world's biggest banks, including Bank of America, JPMorgan Chase, HSBC, Citigroup and Barclays, reflecting concern over their exposure to the violent swings in global financial markets. The downgrades late yesterday ultimately are a measure of Moody's view on the ability of the banks to repay their debts. Moody's didn't treat all large banks alike. It so (Photo by Viviane Moos/Corbis via Getty Images)
A man doing a banking transaction at a Citibank ATM fast cash machine. (Photo: by Viviane Moos/Corbis via Getty Images)

Money market and asset management accounts

Checking accounts themselves are available with interest — or dividend-paying features, again usually requiring minimum balances.

Another alternative is the money market account or money market mutual fund. Here. your deposits earn based on the performance of a portfolio, or mutual fund, of large money market securities such as commercial paper, Treasury bills, banker's acceptances, and negotiable certificates of deposit.

These accounts require minimum balances that usually are higher than the minimums of regular savings accounts, but often pay the highest interest or dividend rates of any type of deposit account.

A variation of a deposit account is the asset management account (aka central asset account), an account that combines savings, checking, credit/debit card services, and a line of credit in one wide-reaching account.

First offered by stock brokerage firms, such accounts might also include the opportunity to invest in mutual funds and retirement plans as well. Asset management accounts often have a sweep feature, which automatically invests unallocated funds into money market accounts. Statements combining its various financial transactions make this kind of account popular with investors as well.

Advantages and disadvantages of deposit accounts

Although many deposit accounts pay relatively low returns, they still hold a number of attractions for investors.

The first and foremost is their high liquidity. Your money in a deposit account is always available, never farther away than your checkbook or the nearest ATM machine.

Even accounts that require higher minimum balances generally charge only small monthly fees if your account balance dips below the minimum, and if you need to, you can close the account at any time. Usually there are no "penalties for early withdrawal" to worry about here.

Security

Second, deposit accounts offer a high degree of security. The Federal Deposit Insurance Corporation (FDIC) insures each deposit account of its member banks up to $250,000 ($250,000 for retirement plan accounts).

Similarly, the National Credit Union Administration (NCUA) insures credit union deposits for the same amounts through its National Credit Union Share Insurance Fund (NCUSIF). Even in the unlikely event that your bank, credit union, or savings and loan association fails, most depositors will receive the full value of their accounts. Most financial institutions belong to the FDIC or NCUA, but some that are state-chartered rely upon whatever backing their states provide.

Even deposit accounts that are not backed and that rely solely on the managers of the portfolio that the deposits are invested in (money market accounts) offer security because they usually are invested in some of the most reliable debt securities available. While you may not make huge returns on your deposit account, at least you have little fear of losing your money.

Widespread availability

Finally, deposit accounts are available to anyone with even a small amount of money. You can save nearly any amount of money in a passbook account, for example. There is no need to meet minimum investment requirements that can run into thousands of dollars with other kinds of investments.

The main disadvantage

Of course, as with any investment, there is a tradeoff between safety and returns.

Even the best deposit accounts usually pay lower rates than "risk-free" investments such as Treasury bonds. And it is not unusual for passbook accounts to pay interest or dividend rates lower than the inflation rate.

As a result, there is little opportunity for your capital to appreciate in real value (over inflation) or beat the kinds of returns possible with other kinds of investment opportunities.

What is an asset management account?

An innovation in deposit accounts introduced in the 1980s is the asset management account, also known to some as the central asset account. This type of account combines into one account many features of financial institutions, and often some investment and additional bookkeeping features. These include checking, savings, credit and debit cards, ATM access, lines of credit, and even brokerage services.

Conveniences of asset management accounts

Asset management accounts are meant to make money management easy. Want to transfer funds from savings into your mutual fund, or borrow money and deposit it into your checking account? One phone call or perhaps one online visit can take care of any transaction. Consolidated statements track and perhaps even categorize all of the accounts' financial transactions, from checks to IRA deposits. When it is time to prepare tax returns, the extra features and consolidated statements of the accounts can be a real boon.

The sweep feature

Another popular feature of asset management accounts is called a sweep. Periodically, as often as daily, unallocated funds above a certain amount in the account are automatically transferred—swept—into an interest- or dividend-bearing money market account. The sweep feature helps make sure your account funds are earning more quickly in a money market account and not languishing in a zero-rate checking account, for instance.

Fees

While you pay a fee for all these services, asset management accounts typically charge only $50 to $150 per year. You may need from $5,000 to $25,000 to start an asset management account, however, and will need to maintain a relatively high minimum balance to maintain the account.

Using deposit accounts in financial planning

Although deposit accounts may not in themselves be high-yield investments, they can play a very important role in your overall financial planning.

Accumulating funds for investing

To begin with, you will need to accumulate funds for investing. Many kinds of investment vehicles require minimum investments of thousands of dollars. Short of waiting for a windfall, the first step in your investment strategy may be to salt away a little at a time until you have the funds to invest.

A deposit account offers a safe and ready way to do your salting. It can also be a good place to keep a supply of liquid cash on hand to take advantage of a "hot" investment opportunity.

Parking your cash between investments

Once you own an investment portfolio, deposit accounts can be a good temporary shelter for funds that are between investments. In the event of a bear market in stocks, for instance, you may need an account to transfer capital to where it can be safe and still earn some interest or dividends while you wait to make your next move.

Deposit accounts also serve as a good alternative for those with short-term needs and/or a low risk tolerance.

Use them for emergency funds

One rule of thumb is for a person to have three to six months' worth of living expenses available for emergencies, such as temporary disability or unemployment or unforeseen large expenses. In addition, there are the expenses you are planning for in the next 12 months or so.

Deposit accounts offer the surest way for your funds to be available. Investments such as stocks can be volatile, and other investments such as certificates of deposit may require you to pay early withdrawal penalties.

The same issues apply to those who are very adverse to risk and volatility. Your capital may not earn as much in a deposit account as in other investment vehicles. However, it will make modest returns in a deposit account and will be there when you need it, leaving you no worry about its availability.

Summary of deposit accounts

While not a high-yield investment opportunity, deposit accounts at savings institutions can play an important role in your investment strategy. Deposit accounts provide a high degree of security and liquidity and can be a good temporary holding place to protect or accumulate investment funds.

Further, today's central asset accounts let you combine investment opportunities with traditional financial institution services for the convenience of one-stop financial management.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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