Banking on a Return: How to get the most out of high-yield savings

By Hilary Kramer
AOL Financial Editor

The best investment choices are the old fashioned ones.

I remember being in grade school and opening my first savings account. I was given a glossy passbook with my name on it. The bank lady stuck its first page into a machine and stamped my deposit -- a lifetime savings of $100 -- in black ink. I thought I was rich. When my dad brought me back a few months later to put in $10, the machine stamped my new deposit plus $2.03. I felt like I had won the lottery -- magically, my money had grown. And, I got a lollipop!

During the past few years, putting your cash in a savings bank often meant a net-negative on your account because the bank fees and year-end taxes on the interest earned wasn’t being covering by your measly 1 percent -- or less -- return. You might have wondered why use a bank at all.

Now, the interest rates of my youth are returning. The Federal Open Market Committee has raised the Federal Funds Rate 17 times since June 2004. When the increases began, the federal funds rate stood at 1.00%. Today the rate is a hefty 5.25%. As a direct result, money market rates and savings bank rates have risen sharply -- providing immense opportunity to the risk-averse investor to cash in on returns that have not been available for years. Usually less than 1 percent only two years ago, many money markets are now paying rates above 5 percent.

The global markets gave a huge sigh of relief when Fed Chairman Bernanke decided to leave rates “as is” during the August 8th FOMC. The Fed chairman explained that “economic growth has moderated from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices." However, more increases may be on their way. Chairman Ben Bernanke and other members still believe that the threat of inflation has not been eradicated. In its statement, the Central Bank indicated that there is room for future rate increases depending on economic growth and inflation reports.

Wall Street is not excited about the rising interest rates -- it slows down growth because companies can’t borrow cheaply to build their new factories or buy new products and services which ultimately translates into more jobs and more demand. But the Street is just as upset about rising rates because individuals and institutions reach the point where the risk of owning stocks is no longer worthwhile. Investors start to rotate out of the stock market and into these high yielding saving products. It becomes a self-fulfilling prophecy -- a vicious cycle as investors sell their stocks to go into liquid, high-yielding cash.

CDs, savings accounts, money market accounts and bank funds aren’t sexy and they don’t have the potential to win you a homerun, but they are low risk and reliable. Today’s investor can earn more than 5 percent without a minimum investment and without having to pay a broker’s fees.

How do you find the highest yield savings? Do your research and explore your options. Certain yields might be higher than others, but also might carry a bit more risk. The best place to compare rates is on bankrate.com. This is an excellent site that gives you a list of rates in each category and divides it up in numerous ways including locally and nationally.

Traditional savings accounts and money market accounts (MMAs). Again, you can find the top-yielding money market and savings accounts listed on sites like www.bankrate.com. Be certain that the bank is FDIC-insured and read the fine print on fees and minimum balances. Many banks now offer no fee accounts with no minimum balances. You may not be getting the absolute highest yield out there through a savings or money market account, but, as long as the bank is FDIC-insured, this is a no-risk investment. Online savings accounts: Banks like www.ingDirect.com and www.HSBC.com offer internet savings accounts with no fees, no minimum balances and often higher rates than you’d get walking into a bank. At the time of this piece, ingDirect’s account offered a yield of 4.27% and HSBC a yield of 4.95%. These are easy to sign up for and use, and carry no risk provided they are FDIC-insured. Make sure, however, that there is an easy way to access your cash through the online account.

Money market mutual funds (MMMF).
The top-yielding money market funds are listed on sites like www.iMoneyNet.com. Money market funds are fairly solid bets, though make sure the yield you see advertised is maintained in the fund projections over the next year. The minimum deposit requirement is often higher than that of the traditional MMA. While these funds are not government-insured like money market accounts, they are heavily regulated and are low-risk. And they make their money through short-term, safe investments. If you are concerned about the very nominal risk of a traditional money market fund, put your money in a fund that invests in government debt, which carries no risk.

Certificates of deposit (CDs).
If you have cash to spare and don’t mind locking it up for 6 months or a year, consider a CD. Unlike a savings account, by locking up your money, you are also locking into a rate. At the time of this article, six-month high-yield CDs averaged 4.63% while one-year CDs averaged 5.04%. And, the best six-month CD in the country yielded 5.40 percent while the best 1-year CD rate in the nation was 5.53 (see the bankrate.com chart which ranks the best CD rates and the corresponding contact information). Remember: the rate is not necessarily going to be higher the longer you are willing to leave your money in the CD. For instance, the five-year rate is lower than the one-year rate, so if you predict rates will continue to rise, lock into a one-year CD, and then in a year, lock into the higher rate CD.

Floating-rate bank-loan funds.
These funds have higher yields than other saving funds. They own portions of bank loans to companies whose payments are tied to short-term interest-rate benchmarks. As long as rates continue to rise, buying into these loans offers superior yields. Jeffrey Kosnett of Kiplinger.com recommends the Fidelity Floating Rate High Income fund (FFRHX) yielding 5.53%. He notes that there is minimal risk and downside, which would only be triggered if the economy takes a nose dive and borrowers default on their payments en masse.

Remember, you will have to declare your interest on your year-end taxes, so your actual rate of return will depend on your tax bracket. If you are in a higher bracket, it pays to consider a tax-exempt money-market fund. While they offer lower nominal yields than traditional money-market funds, the savings in taxes will positively offset the difference.

Bankrate.com’s McBride cautions investors not to put all their eggs (or cash) into one basket: "Knee jerk returns won't get you to your financial goal. Now is the time to re-evaluate your portfolio and diversification may be the answer. Diversification includes putting a little more money into cash investments which have fared well as interest rates have climbed."

At the end of the day, if you put some of your liquid assets into smart high yield savings, you’ll have made money.

Now go buy yourself a lollipop.

Visit her at hilarykramer.com.