You are working hard and making good money. Then you spend that money wisely and tuck away a part of your salary in your savings account each month to build your nest egg. With your bank even paying you some interest on the money and helping you save, it sounds like a no-brainer- right? Think again.
Interest on Savings Account
Ever wondered how much interest you earn on your hard-earned money when you put it in a savings or checking bank account? As of now, average interest rate big banks pay on a savings account is 0.1%. So if you deposit $100 in savings account today, you will earn $0.01 interest in a year. There are some high yield savings accounts that pay up to 1% per year but even that is not something to write home about. With that kind of interest, you bank is guaranteed to help you get poor slowly.
How is that possible you ask. Your banker said savings account is the best place to save. Wrong again!
Benefits of Savings Account
Savings account does offer some benefits. Your money is completely safe in a savings account. You have access to the entire amount whenever you need it. Plus you get a penny more a year for every $100 you deposit. There is also additional insurance provided by FDIC to guarantee that you will get your money back in case something goes wrong with the bank. Despite all these benefits, savings account is not the best place to park your money. Why? The simple answer is because of inflation.
What is Inflation?
Inflation is the general increase in prices of goods and services each year. It is measured as a percentage and indicates how much prices of goods and services go up in a year. As inflation rises, each dollar will buy a smaller percentage of a good or service. For example, if annual inflation rate is 2%, then a bread or a dozen donuts that costs $1 today will cost $1.02 in a year. So you need $1.02 to purchase the same thing that you can buy today for $1. A burger and coke that costs $4 today will cost $4.08 a year later.
As per government’s CPI index, the current rate of inflation is 2.1%. Now if you keep your money in savings account, you are only receiving 1% on your money, but if prices rise by 2.1%, then the purchasing power of your savings will decline by 1.1%. The value of liquidity you get from keeping money in savings account is slightly higher but in inflation-adjusted basis, you are loosing purchasing power. So your savings need to grow by at least ~2% for you to be able to buy the same things next year as you can buy today with that dollar. In other words, if you are earning less than inflation rate on your money, you are loosing purchasing power.
Long Term Impact of keeping Money in Savings Account
The impact over long-term is more pronounced than you can imagine. Lets take an example. Lets say you have $10,000 that you keep in your savings account for 5 years and earn 1% interest each year. If inflation rises by 2% each year during the same time, here is the impact in five years.
Year 1: You need $10,200 to buy what used to cost $10,000 but your savings grew to $10,100
Year 2: You need $10,404 to buy what used to cost $10,000 but your savings grew to $10,201
Year 3: You need $10,612 to buy what used to cost $10,000 but your savings grew to $10,303
Year 4: You need $10824 to buy what used to cost $10,000 but your savings grew to $10,406
Year 5: You need $11040 to buy what used to cost $10,000 but your savings grew to $10,510
How to think about Savings account
In personal finance, you need to think about buckets of money. You have different buckets for different purposes and each bucket serves a different purpose. Savings accounts should be thought of a place to keep money safe where you can have quick access to it but it’s not necessarily the best place to keep money that you want to grow. You need to keep some money in savings account for the emergency fund. This is the money that you absolutely do not want to lose and you want a guarantee from the bank to keep your money safe. This could be anywhere from 2 months to a year of living expenses depending on various factors and what you are comfortable with. Any additional money you save should go into your investment accounts where it can grow.
I usually keep enough money to pay my bills for 2 months ($15,000) in my savings account. How I decided on that amount is a topic for different post. If you are just begging to learn about personal finance, choose between 4 to 8 months of savings depending on your comfort level to keep in your savings account. The rest of your money should find a place in other accounts where you can invest it for the long-term.
What do you think about your savings accounts and how do you use it? How much money do you keep in your savings account? Share your thoughts.