Question

Julie has accumulated 1,000 dollars in a bank savings account, which pays 2.7 percent interest. She investigates several options and finds that she can invest her money in a 1 -year Treasury note paying 4.4 percent interest, a 1-year CD paying 3.9 percent interest, or a money market mutual fund with an average yield of 3.7 percent. What are the pros and cons of each of these investment options?

Short answer

The Treasury note yields the highest interest of $44, with low risk but less liquidity.

Step-by-step solution

Calculate Interest for Savings Account

Julie currently has $1,000 in a bank savings account that pays 2.7% interest. To find out how much interest she will earn in one year, use the formula for simple interest: \ Interest = Principal \times Rate. Substitute the values to get: \( Interest = 1000 \times 0.027 = 27 \) dollars.

Calculate Interest for Treasury Note

The 1-year Treasury note offers a 4.4% interest rate. Use the same simple interest formula: \( Interest = 1000 \times 0.044 = 44 \) dollars.

Calculate Interest for CD

The 1-year CD has a 3.9% interest rate. Again, use the simple interest formula: \ \( Interest = 1000 \times 0.039 = 39 \) dollars.

Calculate Interest for Money Market Fund

The money market mutual fund offers a 3.7% average yield. Using the simple interest formula: \( Interest = 1000 \times 0.037 = 37 \) dollars.

Compare the Options

List the interest earnings: - Savings Account: $27 - Treasury Note: $44 - CD: $39 - Money Market Fund: $37. The Treasury note offers the highest interest with $44, while the savings account offers the lowest with $27.

Consider the Pros and Cons

1. **Savings Account**: - Pros: Liquidity and safety, funds are easily accessible. - Cons: Lowest interest of all options. 2. **Treasury Note**: - Pros: Highest interest, backed by the government, hence low risk. - Cons: Money is tied up for the duration of the note period. 3. **Certificate of Deposit (CD)**: - Pros: Higher interest than savings account, generally low risk. - Cons: May have penalties for early withdrawal. 4. **Money Market Fund**: - Pros: Generally safe and slightly better interest than savings account. - Cons: Might not be insured, and interest rates can fluctuate.

Key concepts

Simple Interest

Simple interest is a straightforward way to calculate the interest earned on an investment or paid on a loan. It is called "simple" because it is based solely on the principal amount and does not account for any interest previously earned. The formula for calculating simple interest is:\[\text{Interest} = \text{Principal} \times \text{Rate}\]Where:

• Principal: The original amount of money invested or loaned.
• Rate: The percentage of the principal that is paid as interest over a certain period.

For example, if Julie has \(1,000 in a bank savings account with a 2.7% interest rate, the interest earned over one year would be calculated as \)1,000 multiplied by 0.027. This equals $27 in interest.
Simple interest provides a clear picture of what one can expect to gain from their investment or owe on a loan after a specific period.

Treasury Note

A Treasury note (T-note) is a type of government bond issued by the U.S. Department of the Treasury. It is popular among investors seeking a low-risk investment. T-notes typically have maturities ranging from 1 to 10 years. In Julie's case, she is considering a 1-year Treasury note paying an interest rate of 4.4%. Investors find T-notes appealing for several reasons:

• Backed by the government: This makes them one of the safest investment options available, reducing the risk of default.
• Fixed interest rate: The interest rate stays the same until maturity, providing predictable returns.

However, investing in a Treasury note does mean that your money will be tied up for the note's duration, in this case, one year. This could be a disadvantage if you need immediate access to your funds. Nonetheless, for those looking for a secure investment with a decent return, T-notes are an excellent choice.

Certificate of Deposit

A Certificate of Deposit (CD) is a savings product that offers a fixed interest rate, and returns your principal at maturity, typically offered by banks and credit unions. In Julie's situation, she is considering a 1-year CD that offers a 3.9% interest rate. CDs offer several advantageous features:

• Higher interest rates: CDs generally offer higher interest rates than regular savings accounts, which means more potential earnings.
• Low risk: CDs are considered a secure investment, often insured by the FDIC or NCUA, adding an extra layer of safety.

However, it's important to note that withdrawing funds from a CD before its maturity date can result in penalties. This makes CDs less liquid than some other types of investments, meaning that you should be willing to set aside your funds for the entire term to take full advantage of the yields offered.

Money Market Fund

A money market fund is a type of mutual fund that invests in short-term, high-quality securities. These funds seek to offer better returns than traditional savings accounts while maintaining a level of safety. Julie's consideration includes a money market fund with a 3.7% average yield. Key aspects of money market funds include:

• Liquidity: They offer relatively easy access to funds, often allowing for check-writing and withdrawals.
• Diversification: By pooling money from many investors, money market funds invest in a diversified portfolio of securities which can reduce risk.

However, unlike a savings account or CD, money market funds are not typically insured, so there is no guarantee of preserving the principal. Additionally, the interest rates can fluctuate based on market conditions, potentially impacting the yield. For investors who prioritize liquidity and are willing to accept a moderate level of risk, money market funds can be a viable option.