You’ve been thinking about a big ticket purchase, like a new car, and would like to pay cash for it from your savings. Your specific target date for the purchase is two years down the road. So, you have the means, and with your target date, you have the ability to schedule how you’re going to set aside the money.
Installment savings accounts
An installment savings account is an FDIC-insured account that requires you to enter a contract with a bank to make regular payments. They have defined maturities and are offered by institutions to help consumers save for specific goals or special occasions. A familiar example is a Holiday Club Savings account that can be opened at any time of the year and automatically distributes accumulated funds on October 1st of each year, just in time for the shopping season. Other examples include Christmas club, vacation and savings accounts for children.
It’s almost like paying a monthly bill, except instead of reducing your debt, you are growing your savings. Payments can be set up with an automatic monthly debit from your checking account.
You usually have to start an installment savings account with a minimum amount. If your target in saving for a car is $20,000, you don’t put that in all at once. You can plan to save in monthly increments until you reach $20,000. If you set up a $20,000 account for two years, you’ll have to put in $833.20 a month for 24 months. You can agree to put in less every month, but will have to agree to leave the money longer.
An installment savings account is good for savers who lack the discipline to systematically squirrel away money. The risk of losing your attractive interest rate if you miss a payment gives you that extra incentive to be diligent.
Certificates of deposit
CD savings rates compare favorably. There are many certificate of deposit options that could perhaps fulfill the same purpose, but the main difference between CD and installment savings offerings is fixed interest, regardless of time. The interest rates on CDs decrease as the time period gets shorter, while installment savings accounts offer the same interest rate regardless of how long or short the time period is before funds are distributed.
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.
With both accounts, banks charge a withdrawal penalty if you want your money back early. With installment savings, the bank can end your contract early if you miss too many payments.
If you open either account, you will receive regular bank statements and a 1099-INT at the end of the year, just as you do for other bank accounts.
Differences in accounts
As compared to CDs, a lot of installment savings accounts have account requirements that must be satisfied in order to earn the fixed interest. Those requirements may include fixed monthly payments, which could be a hassle considering the account will likely not be an essential focus.
Another disadvantage of an installment savings account is that you commit to put a set amount into the account each month for a certain period of time. That reduces your flexibility with your monthly income. With ordinary savings, you can skip a month if things are tight. You can’t do that with installment savings, without paying a penalty or losing interest.
Your money is tied up until the end of the agreed term of installment savings accounts. That can be one year or five. If you take out any money before the term ends, you’ll pay a penalty. The amount of the penalty will vary with the specifics of your account, but often will be 90 to 180 days worth of interest.
You are locked into a fixed interest rate with installment savings. You agree on an interest rate when you open the account with the bank or savings institution. If savings rates go up suddenly, you can’t switch to take advantage of better rates. Your interest will typically be credited to your account monthly, but you can’t get it until the end of the term.
Installment savings accounts are a great way for undisciplined savers to reach a savings goal like save for a car. But for savers who want to maximize their return and flexibility, CDs may be a better alternative.
Higher interest rates
What happens if interest rates go higher? 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 imminent are interest rates hikes? The latest word from the Federal Reserve’s policy making committee said the U.S. economy has recovered enough since 2008 for the central bank to end its stimulus program that has injected more than $4 trillion into the economy. The scheduled end of quantitative easing came as the American economy was adding jobs at the fastest pace since the Great Recession began in December 2008.
The Federal Open Market Committee also said, as expected, that it will continue waiting “a considerable time” after the end of its asset-purchasing program to raise interest rates, “especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.”
Weak inflation, at about 1.7 percent, is giving the Fed more time to raise interest rates. If economic data indicate faster progress toward 2 percent inflation and maximum employment, increases in borrowing costs are likely to occur sooner rather than later, the Committee said.
For now, the Fed is expected to start raising short-term interest rates from near zero around the middle of 2015.