Are You Losing Money In A Savings Account? – A Quick Guide
Savings accounts have been around for as long as there have been banks. Some people believe they aren’t worth it because they actually lose you money. How is this possible and does this mean you shouldn’t use a savings account?
Are you losing money in a savings account?
In short, yes you most likely are. If you are using a savings or checking account to hold the majority of your assets, in this case, cash, then over time you are losing money in relation to inflation. High-yield money market and traditional investment accounts offer higher rates of return that on average, beat inflation and result in your money grow exponentially.
This doesn’t mean that checking and savings accounts don’t have their place in your financial plan because they absolutely do. You should have both but as I will explain later on in this article, you need to work them into your plan in an optimal way.
How A Savings Account Loses You Money
A savings account loses your money because of inflation but what exactly is inflation? Whenever you have heard the term inflation used, it has probably been in a negative context. Inflation is a problem but there are some positive things about it. Have your older family members ever bragged to you about how a piece of gum used to cost $.05 but now costs $1.00? That is due to inflation.
Inflation is the relative increase in the price of a select basket of goods over a period of time. This article isn’t meant to be a lesson in economics so if you want to learn more check out the Investopedia article taking you through every part of inflation.
What you do need to know is that inflation averages around 2% per year. So if you paid $1.00 for that pack of gum this year then next year it will cost $1.02 or a 2% increase. How does this affect your savings account though?
Well, your savings account has an interest rate attached to it. As of the writing of this article, my Wealthfront Online High-Yield Savings Account has an interest rate of 1.27%. On the other hand, my local bank savings account offers a .25% interest rate.
The difference in these interest rates isn’t important for understanding how a savings account is losing you money. What is important is that the interest rates they offer are less than the average inflation of 2%. Leaving that money in a low earning account causes missed opportunities. And when the price of goods is increasing at a higher rate than your money is earning, you are losing value and technically losing money.
The Math Behind The Money
This article wouldn’t be complete without putting some math behind this statement. Math is hard to dispute and I think it can really drive home why it is important to understand this concept.
In the chart below I outlined three account options. Regular checking and savings account at your local bank and then an online account through Wealthfront. In the header row, you’ll see the interest rates associated with that account. I also used a 2% inflation rate even though it has been slightly higher as of recently.
How can this happen? How can my account value go down? Well, it doesn’t so let me explain. Your account value will go up but the relative value of your money in that account will go down. The amount of product you’ll be able to buy with that original $10,000 has decreased (the bubble gum example). For the sake of simplicity, imagine that Year 1 in the chart is this year, 2020. Based on the rate of inflation and earning no interest, in 2030 $10,000 will only be able to buy you $8,337 worth of goods. The amounts differ as you can see based on how hard your money is working for you (the interest rate). So you need your money to earn as much as possible to make up for the loss of value due to inflation.
How I Would Recommend Using A Savings Account
Savings accounts can be great tools to use in your financial plan if you use them for short-term goals. Goals like:
- Buying a house
- Buying a car
- Saving for a trip
- Saving for any major purchase
These are goals you are going to be paying for in the next 6-18 months so the effects of inflation won’t have such a major impact. In addition, your continuous transfers into this account will make it seem like inflation isn’t even happening.
Lastly, the interest you earn is a guaranteed return. The bank is going to pay you that interest rate no matter what. On the other hand, when you invest in the market and buy a stock, for example, nothing is guaranteed. You can learn more about the pros and cons of a savings account by reading my article: Are Savings Accounts Worth It? The 6 Pros and Cons
If you want to learn more about setting up, using, and maximizing the use of a savings account then make sure you check out my course, Money Made Easy. I show you step-by-step how to set up and fund an account. I also take you through using it to plan for large purchases.
What Should You Use In The Long-Term?
If you are planning on saving for the long-term, also known as retirement saving, then I would highly suggest opening up an investment account.
There is a major difference between investing and saving. Yet often the words are used interchangeably. Here is the difference; saving is for the short term (6 months – 3 years) like we just discussed while investing is over the long term (4 years – you die).
Holding a year or two of cash in a savings account as an emergency fund is always a good idea. It will never hurt to have that cash at your disposal because life happens. But holding anything above that may be costing you hundreds of thousands of dollars in long-term growth.
Historically, index funds that reflect the U.S. Stock market have returned 7% annually. The difference between 1.27% and 7% may not seem like much but through compounding interest, it piles up.
Moreover, that 7% interest rate you can earn in an investment account is much higher than the 2% inflation average. Here is a chart to show you what would happen to that same $10,000:
Going from $10,000 to over $15,000 is the power of compounding interest working for you.
The Bottom Line
Yes, savings account over a long period of time can lose you money. You may have the physical cash but the purchasing power of that cash has diminished and there is nothing any of us can do about it. Inflation is actually a good thing when it is balanced and so far, it is just a fact of life that isn’t going anywhere.
Find a way to work a savings account into your financial plan because they are great tools. Set up automation by either splitting up your paycheck or transferring money from a different account every month.
But, understand the reasons why to use that savings account and make an educated transfer of your money into a high-yielding account if it makes sense for you. Now more than ever, it is important to think about the future and get prepared. No one will watch out for you but you.
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