How Much Does FDIC Insurance Cost Consumers?

So how much did you pay in FDIC insurance last year? If you think the answer is zero, think again. While it's true that financial institutions, not consumers, must contribute to the FDIC insurance fund, they pass those costs on to banking customers in the form of lower rates. And that raises an important question for anybody with cash in an FDIC-insured account; how much is the $250,000 in coverage costing you?

This hit home for me recently as I looked for a place to park some cash. Even a high interest savings account at online banks are only paying a little over 1% APY. But if you look for similar savings vehicles that are not FDIC insured, you begin to realize just how much peace-of-mind really costs. Here are two examples:

Non-FDIC Insured Demand Accounts

While most certificates of deposit you see advertised are FDIC-insured, there are options that are not insured. For example, charitable organizations may seek to raise funding through certificates of deposit to support the work of the organization.

AG Financial Solutions, for example, provides loans to churches looking to fund building projects. To raise money for its lending activities, it offers 30-day demand deposits and CDs ranging from 6 months to 5 years. Money invested with AG Financial Solutions is not FDIC-insured, which makes for a perfect comparison for our purposes.

As an example, the best 6-month CD rates today from an FDIC-insured institution come in at just under 1.00% APY. At AG Financial Solutions, its 6-month CD pays 2.25% APY. That spread is a significant premium to pay for insurance.

I should point out that I've never invested with AG Financial Solutions and have no affiliation with the organization. I do have friends who have invested with them for years, and they seem to prefer the higher rates over FDIC insurance.

Short-term Investment Grade Bond Funds

Another reasonable comparison to FDIC-insured deposit accounts are investment grade, short term corporate bonds or bond funds. While any bond fund presents risks not found in a savings account or CD, an investment grade rating combined with a short duration reduces both credit and interest rate risk significantly. As such, these bonds are a potential alternative to low paying deposit accounts. So how do these investments stack up to an FDIC-insured deposit?

The Vanguard Short-Term Investment-Grade Fund (VFSTX) is a good place to start. It currently sports an SEC Yield (30-day yield to maturity) of 1.78%. Of course, performance almost never tracks the SEC Yield. As interest rates rise and fall, for example, the price of the fund moves in the opposite direction. Since 1983, the fund has had a negative return in just three years. The worst year was 2008 with a return of -4.74%, followed in 2009 with the fund's best year of 14.03%. Load adjusted returns for the past 10 years settle in at 4.45%.

While the comparison of a bond fund to an FDIC-insured deposit account is not perfect, it does raise the question of just how much cash should be placed in a deposit account that is paying historically low rates.

The Takeaway

So what does all this mean? First, it doesn't mean that the spread in yields described above results entirely from the cost of FDIC insurance. The rate a bank is willing to pay on an FDIC-insured deposit depends on many factors, including the bank's capital requirements, Fed rates, and operating costs, to name a few. Second, and more importantly, whatever the cause of the spread in yields, a good argument can be made that consumers overestimate the value of FDIC insurance.

This post comes from DoughRoller.net, a popular personal finance and investing blog.