I hate to be the bearer of bad news, but the belief that you make money from the interest on your savings account is completely wrong.
Every dollar you have in the bank right now is losing value.
At this point, you have 2 options. You can either press the small X at the top of your screen, or you can keep reading to find out why money is draining from your savings account and what you can do to fix it.
Real and Nominal Rates
Remember that class you had to take in high school called macroeconomics? You probably executed a full scale brain dump after the final exam, so allow me to reintroduce a key topic: the difference between nominal and real interest rates.
A nominal rate is the percentage of an account’s value that is paid every year as interest.
The real rate, on the other hand, is the interest rate adjusted for inflation.
real rate = nominal rate % – inflation rate %.
Right now, in an unprecedentedly low-rate environment, the average savings account is paying .06% in interest (FDIC). That means that for every $1,000 you stash in the bank, you earn a whopping 60 cents per year. Even if you find an extraordinarily good deal from an online bank, you’re looking at a measly 1%. It doesn’t sound like much, but at least it’s something, right?
Well, not really.
In the US, the current rate of inflation is 2.1% (US Inflation Calculator). That means that the real interest rate of your savings account is -2.04%.
Every day that your money sits in a savings account, the real value (i.e. the purchasing power) is decreasing.
The question is, how much of an impact does this actually have? Let’s do the math.
The following graph shows the change in real value over time of $1000 put in a savings account with the current rates for average interest and inflation. The real rate is -2.04%.
As you can see, a seemingly minor issue, like the impact of inflation on your savings account, can decimate your purchasing power.
After 30 years, that $1,000 is almost cut in half to $539.
So, how do I suggest you use this information? Should you abandon savings accounts altogether? Of course not! But, if you plan on using a savings account to stock up for retirement, then you can take that idea and throw it out a 17th story window.
When to use Savings Accounts
Savings accounts are still powerful tools; just don’t think that you can use them to build long term wealth.
Instead, look at a savings account as a safe way to store liquid cash.
Here are some great ways to use them:
- To store your emergency fund, a topic I covered in depth with this series.
- To save for a specific purchase that you will make within a few years, such as a vacation, a new car, or college tuition payments.
- To hold several months worth of cash if you are in retirement.
Hopefully this helps you view wealth from a “real value” or “purchasing power” perspective. It’s easy to focus on nominal, percentage based returns and forget that you could actually be losing money with a savings account.
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What are your thoughts on savings accounts and their uses? Leave a comment below to start the conversation. I’d love to hear your opinion!