Where to Invest Short Term Money

April 17, 2013

We recently got this question on our Facebook page: “I am looking for short term investment strategies, 4 to 7 year span for some inheritance money that would then be liquidated to pay for college.” It’s a common question. After all, with interest rates near record lows and the stock market as volatile as ever, it can be tough to figure out what to do with money you need in just a few years.

First, let’s look at what NOT to do. As tempting as it may be to invest it all in a rising stock market, that could be a big mistake. Since stocks are extremely volatile in the short run, you never know when the next correction/crash is coming. If you can wait for the recovery, it’s not such a big deal. But if you need the money soon, you may be forced to turn your paper loss into a real one.

While bonds have traditionally been seen as conservative investments, they aren’t so safe either. That’s because bond prices tend to fall when interest rates go up. With interest rates at historic lows and the economy possibly going into recovery, guess which way interest rates might go next?

So what is this investor to do? Here are some options to consider in order of expected return:

Balanced Portfolio

Pros: In this case, it may be worth taking some risk for a higher expected return and investing the money in a balanced portfolio. Why? First, some of the money may not be needed for 5 years, which is often seen as the cutoff for taking some risk. If the portfolio does lose value, there’s always the option to take student loans and pay them off when the portfolio recovers.

Cons: You’re still taking risk. This is also not a good idea for other short term needs like an emergency fund or a down payment on a home in which low interest student loans are not an option.

Time Period: 5 or more years
Best for: any
Limit: none
Risk level: moderate

529 Age-Based Portfolio

Pros: Since this is college money, you could invest it in a 529 plan for tax-free growth for education expenses. Most of those plans have age-based portfolios in which the investments automatically become more conservative as the child gets closer to college age. You might also get a state income tax deduction if you contribute to your state’s plan.

Cons: There may be a 10% penalty on the earnings if you use it for something else. In addition, the withdrawals can reduce financial aid eligibility so try to use the 529 plans as late as possible. If you wait until the last year, all the financial aid will already have been awarded.

Time Period: any
Best for: post-secondary education expenses
Limit: up to $320k
Risk level: varies with child’s age

Rewards Checking Account

Pros: Like other checking accounts, these accounts are FDIC-insured and very accessible but unlike most checking accounts, they don’t tend to charge maintenance fees and can pay as much as 4%. Some even reimburse your ATM fees.

Cons: So what’s the catch? There’s a limit of how much you can earn with that rate and you have to meet certain requirements like using direct deposit, electronic statements, and your debit card for a minimum number of transactions each month. Since these are mostly small community banks and credit unions, you’re also unlikely to find one near you and would have to do your banking online. You can search for one based on location, account balance, interest rate, and requirements at Deposit Accounts.

Time Period: any
Best for: any
Limit: varies with institution
Risk level: FDIC-insured

Series I US Government Savings Bonds

Pros: These bonds are fully-backed by the US government, are tax-deferred (and may be tax-free if used for your children’s education expenses), do not fluctuate in value, and currently pay an interest rate of 1.76% that adjusts with inflation.

Cons: Each person can only purchase up to $10k per year on Treasury Direct plus another $5k per year from tax refunds. After you purchase them, you can’t cash them in the first 12 months and you lose the last 3 months of interest if you cash them in the first 5 years. That being said, you’ll still probably be ahead of other low interest options even after the penalty.

Time Period: 1-30 years
Best for: education expenses for children
Amount: up to $10k per year online plus $5k per year in tax refunds
Risk level: fully government backed

CDs

Pros: They’re FDIC-insured and don’t fluctuate in value. You can also find ones that pay more than your local bank on sites like bankrate.com.

Cons: They’re still not paying a whole lot more than your local bank account and as little as that interest is, you might lose some of it if you cash them in early.

Time Period: varies
Best for: any
Amount: varies
Risk level: FDIC-insured

As you can see, your local bank’s savings account isn’t your only option for short-term savings. But there’s no one right answer for which of these alternatives is the best. It all depends on when you need the money, what the purpose for it is, how much you have, and how much risk you’re comfortable with.

Have a question of your own but not sure who to trust? You can submit it to us on Facebook or Twitter for an unbiased answer.