Understanding the Basics and Benefits of Interest-Bearing Accounts

Key Takeaways

• Types of interest-bearing accounts include interest-bearing checking accounts, savings accounts, high-yield online savings accounts, money market accounts and certificates of deposit.

• Depositors are paid for placing their money with a financial institution, which in turn uses the cash to make loans or investments upon which it earns interest, a percentage of which is paid to the depositor in exchange for use of the funds.

• Interest payments are typically quite low, particularly when compared to the potential for gains traditional and alternative investments offer.

Useful tools for earning interest on cash while maintaining a degree of liquidity, interest-bearing accounts take a number of different forms. These include interest-bearing checking accounts, savings accounts, high-yield online savings accounts, money market accounts and certificates of deposit. The primary benefit of these types of accounts are the potential they hold to generate interest payments on savings.

Essentially, depositors are paid for placing their money with banks or other types of financial institutions, which in turn use the cash to make loans or investments upon which they earn interest. They then pay a percentage of those earnings to depositors. This provides an opportunity to realize a return on cash, which can be particularly useful during periods of rising interest rates.

How Does an Interest Bearing Account Work?

Opening an interest bearing account is a relatively straightforward process. One chooses an institution with which to place the deposit and opens an account. There can sometimes be a requirement to provide a certain minimum deposit and maintain a specified balance in order to earn interest payments on the deposit. Some interest-bearing accounts also come with monthly maintenance fees to consider.

Another thing of which to be aware is the potential for withdrawal penalties if more than a certain number of transactions occur over a prescribed period of time. Because the financial institutions use the money, they want to make sure there will be enough cash in their coffers to cover those opportunities. As a result, they implement safeguards to discourage depositors from withdrawing all of their funds at once. These usually take the form of fees. This makes it important to understand the terms imposed and how they may affect a depositor’s ability to use their money as they see fit.

What Are The Different Types of Interest Bearing Accounts?

As covered above, the most common types of interest bearing accounts include: checking, traditional savings, high-yield online savings, money market accounts and certificates of deposit (CDs). Each of these accounts function differently.

They also have varying requirements and caveats.

1. Interest-Bearing Checking Accounts – As the term implies, these checking accounts pay interest. While the rates they pay are typically quite low, interest-bearing checking accounts do couple maximum liquidity with the ability to earn. Some such accounts pay a flat rate each month, while others calculate it based upon the average balance. The amount of cash kept in the account can have an effect on the rate paid. It is also important to be mindful of the associated fees, as they can be greater than the interest paid under certain circumstances.
   
2. Traditional Savings Account – Offered by most banks and credit unions, the basic savings account is highly liquid and supports funds transfers between savings and checking accounts. This makes it a useful place to keep an emergency fund. These accounts are easy to open and easy to access with no penalties, fees, or minimum balance requirements. Here, too, however, the interest paid is very low, sometimes even less than one tenth of one percent. The primary benefit of this type of interest-bearing account is convenience.
   
3. High-Yield Savings Account – These accounts offer higher rates than traditional savings accounts and are offered through online banks, credit unions and traditional banks. Online institutions can usually afford to pay higher rates than the others because they are free of the expenses associated with brick-and-mortar institutions. They generally impose fewer fees as well. Some online banks also forego monthly maintenance fees, waive minimum balance requirements, and do not require a set amount for the initial deposits.
   
4. Money Market Accounts – Functioning as sort of a hybrid between checking and savings accounts, money market accounts permit limited check writing and debit card usage. They also offer higher rates of interest than traditional savings accounts. In exchange, they require the deposit of substantial amounts and minimum balances to keep the account. This can be anywhere between $5,000 and $10,000, depending upon the institution. In some instances, withdrawals and/or debit card purchases can be limited to six per month.
   
5. Certificates of Deposit – These accounts pay a fixed rate of interest in exchange for meeting their time requirements. Generally, the longer funds are kept in a CD, the higher the interest rate they will earn. Time requirements can range from months to years. In most cases, a CD can be a useful harbor for funds for which there is no short-term need, as early withdrawals can trigger penalties. These accounts can be useful when accumulating a down payment for a house or a car or some other large purchase for which financing will be required. Minimum deposit requirements typically accompany these accounts, which can range from as little as $200 to as much as $10,000.

Benefits and Limitations of Interest Bearing Accounts

The obvious benefit of these types of accounts is the accumulation of interest payments on funds that would otherwise languish in a traditional checking account, earning no interest at all. Accounts held with FDIC-insured banks are guaranteed up to $250,000 per depositor. Affiliated institutions will typically state, “Member FDIC.” Interest-bearing accounts with credit unions are guaranteed when the institution is a member of the National Credit Union Association (NCUA). Moreover, these accounts provide a place to keep money in which the depositor will be less tempted to spend it.

Limitations include the opportunity cost of keeping money in one of these accounts, as opposed to investing it in an asset capable of returning a more significant gain. Further, most interest bearing accounts have fees to consider. Many also impose minimum deposit and balance requirements—as well as withdrawal limitations.

In other words, while they do offer a degree of liquidity, it can be limited according to the requirements imposed by the institution offering the account.

How Interest is Calculated on an Interest-Bearing Account

Interest rates vary, based upon the type of account and the institution offering it. Savings accounts usually employ compound interest, in that earned interest is added to the principal and subsequent interest payments are calculated based upon the accumulated amounts. An annual percentage yield (APY) is usually applied to calculate the amount of interest paid.

Accounts that pay simple interest offer a set percentage based upon the amount of money invested each year. Rates can also be fixed or variable and dependent upon the balance of the account.

Interest-Bearing Accounts and Investing

Some investment firms offer cash management accounts which function in a fashion similar to interest bearing accounts. Investors saving to meet long-term goals, such as retirement or college funds can use Roth IRAs, 529 plans and other such vehicles to earn interest on savings.

Interest-bearing accounts can also be useful when accumulating funds to meet a minimum investment in potentially more lucrative asset classes, while shielding those funds from potential market volatility.

However, interest-bearing accounts can also deprive investors of opportunities to realize more significant gains, as well as portfolio diversification with traditional or alternative investments, if relied upon as a long-term strategy.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments. It should be understood that these risks are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices and carry additional risk of loss. This includes the possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments. Further, these investments are generally considered to be illiquid, due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information. Diversification does not ensure a profit or protect against a loss in a declining market.