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As you work toward your financial goals, there are a variety of tools that can help you save and grow your money. Two you might be considering are savings accounts and mutual funds. While both can help you save for the future, they work in very different ways.Savings accounts provide a safe place to store money you may need in the near term, while earning a little bit interest. Mutual funds, on the other hand, are investments that come with risk but have the potential for higher returns. You generally consider investing when you have a longer-term horizon, such as for children's college funds or your retirement.Read on to learn more about savings accounts vs. mutual funds, including how each financial vehicle works, their pros and cons, and which option to use when.
What Is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from multiple investors to purchase stocks, bonds, and other assets. Mutual funds typically invest in a large number of securities, allowing investors to diversify their portfolios and reduce their risk at a low cost.When you buy a mutual fund share, you don’t directly own the stock or other investments held by the fund. Instead, you own shares in the mutual fund. You also share equally in the profits or losses of the fund’s total holdings.
How Mutual Funds Work
Mutual funds can invest in all sorts of assets, including stocks, bonds, commodities, real estate, and more. They may be designed to track a specific equity index, or they may follow their own investment strategy. Different types of mutual funds include:
Bond Funds Also called fixed-income funds, these mutual funds hold a variety of bonds, including corporate and government bonds, that pay a set rate of return. They are generally safe but can be affected by changes in market interest rates.
Equity Funds These mutual funds hold corporate stocks, and tend to be riskier than bond funds. They may follow a variety of investment strategies. For example, growth funds may focus on stocks that have higher potential returns, while income funds may invest in stocks that regularly pay out dividends.
Index funds Instead of aiming to beat the performance of the overall market, index funds simply try to match the performance of a given index, such as the S&P 500. Since they require less hand-on management, fees are typically lower.
Target date funds These mutual funds can work well when you know the date you’ll need the money. They hold a mix of stocks, bonds, and other investments and, over time, will shift from an allocation focused on returns to a more conservative allocation focused on preserving wealth.
Mutual funds may be passively or actively managed. Passively managed funds tend to closely track a market index and are managed by a computer algorithm. Actively managed funds, which are more common, are managed by professional fund managers with access to market data and expertise that helps them make decisions that may provide potentially higher returns. Because actual humans are doing the investing, actively managed funds tend to charge higher fees than passively managed funds. You can buy shares of mutual funds directly from the fund or through a broker for the fund. You can buy these shares inside a tax-advantaged account, such as a 401(k), individual retirement account (IRA), or 529 plan, or inside a taxable brokerage account. Recommended: Brokerage Accounts vs Savings Accounts
Benefits and Risks of Mutual Funds
There are both advantages and disadvantages to owning mutual funds. One of the key benefits is diversification. Mutual funds essentially provide investors with ready-made diversified portfolios that can help manage risk. With actively managed mutual funds, there is a professional manager on your side working to maximize returns. Mutual funds are also relatively liquid, and can be redeemed on any day the market is open (though it may take a day or two to be able to access your cash).Of course, mutual funds may can also help you make money. This may happen in a few different ways. Investments held by mutual funds may earn dividends, which are passed on to investors, less fees. The fund may also experience capital gains if it sells investments that have increased in value, which are distributed to investors minus capital losses. Finally, the value of the mutual fund itself might increase, and when investors sell their shares, they may earn capital gains. However, mutual funds also come with risks. The securities that are held by the fund can lose some or all of their value. So investors could potentially lose their investment. Dividends and capital gains are also subject to market conditions. While index mutual funds can be a low-cost way to invest in the market, fees charged by other funds can be relatively high, hindering your long-term wealth-building. Some mutual funds may also charge commissions – called loads – that can also put a dent in your returns (however you can avoid this by purchasing no-load funds). It’s a good idea to compare funds by looking at each fund’s expense ratio. The lower the ratio, the cheaper the fund is to buy and hold.
Mutual Funds vs. Savings Accounts
Savings accounts are different from mutual funds. Mutual funds are investment vehicles, while savings accounts are interest-bearing deposit accounts. These accounts are offered by traditional banks, online banks, and credit unions. Savings accounts pay interest on your deposits, expressed as an annual percentage yield (APY). While returns can be relatively low, there’s virtually no risk involved. The Federal Deposit Insurance Corporation (FDIC) or National Credit Union Association (NCUA) insures savings accounts up to $250,000 per account holder, per institution, should the bank or credit union fail.The money in a savings account is liquid (meaning you can access it when you need it). However, you are typically limited to a certain number withdrawals per month, often six or nine. While federal rules restricting savings account owners to six withdrawals per month have been suspended, banks and credit unions can still cap the number of withdrawals you’re allowed to make and charge fees if you exceed the max.Savings account can be ideal for short-term savings goals, such as buying a car, going on vacation, and building your emergency fund. Even the highest APYs, however, may not keep up with inflation, which means that they generally aren’t the best choice for building wealth over time.To better understand the difference between savings accounts vs. mutual funds, here’s a side-by-side comparison.
Mutual Funds
Savings Accounts
Risk
Risk involved
Virtually none
Returns
Potentially high
Relatively low
Liquidity
Can take a day or two to sell shares and access cash
Money is easily accessible (though you may be limited to a certain number of withdrawals per month)
Mutual funds can be appropriate for someone looking to invest money for the longer-term and prefers to access a broadly diversified portfolio, rather than pick and choose stocks. Within mutual funds, there are a lot of options to choose from.Index funds can provide a cheaper mutual fund alternative to actively managed funds that cost more but offer the potential to outperform a market benchmark. Investors looking for a set-it-and-forget approach to portfolio building may consider target-date funds since these are automatically rebalanced as the investors nears their target goal, such as retirement age or when a child will go to college. Investors who are looking for potentially cheaper alternatives to mutual funds may consider an exchange-traded fund (ETF). Like mutual funds, ETFs hold baskets of securities that provide investors an easy way to build a diverse portfolio. Frequently, ETFs are passively managed, tracking various market indexes. Passive management helps make them cheaper than actively managed mutual funds.
Can You Use Mutual Funds and Savings Accounts Together?
Yes, you can use mutual funds and savings accounts together as tools in your financial plan and many people do. You might choose a high-yield savings account to set aside money for financial goals you want to accomplish within the next few months or years, such as going on vacation, buying a car, or paying for a wedding. Since these are short-term goals, you don’t want to take any risks with your money. With a savings account, returns are guaranteed. At the same time, you might choose a mutual fund for savings goals that are at least five years away. A longer time frame helps you ride out the ups and downs of the market and can allow your savings to recover from market drops.
The Takeaway
Mutual funds, like other investments, can be an important tool for building long-term wealth. They offer an easy way to build a diverse portfolio that helps manage some of the risks involved in investing. However, there are still risks involved.If you are looking to save money for a goal that is several months or years away, you’ll likely be better off opening a savings account. The money is federally insured, and you’ll earn interest on your deposits. This can help it grow over time, especially if you choose a high-yield savings account.If you’re looking for the best return on your savings, Lantern by SoFi can help. With our online banking marketplace, it’s fast and easy to compare high-yield savings accounts based on APY, fees, and balance minimums.Lantern can help you compare online savings accounts and find today’s best rate.
Frequently Asked Questions
Is a mutual fund better than a savings account?
Should I keep my savings in a mutual fund?
Does a mutual fund earn interest like a savings account?
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About the Author
Austin Kilham
Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
