One of personal finance best practices is to have 3 to 6 months of an emergency fund. Since the money has to be accessible and you can’t risk losing the money, the best place to keep your emergency fund is in a high yield savings account or a short-term CD. These are also the best accounts to keep the money you’re saving for short-term goals.
Unfortunately, while your money is earning 1 to 2 percent in these accounts and generating taxable income for you, you are in fact losing money.
Negative Real Return
Basically, inflation takes more away than you gained from the interest earned from these accounts, resulting in the reduction of your purchasing power.
I think the best way to demonstrate this concept is with a real-life example:
- The best savings account rate is 2.44% APY
- The Consumer Price Index (CPI) inflation rate from July 2018 to June 2019 is 2.0%, according to the Bureau of Labor Statistics.
Based on these data, the Real Rate of Return is 2.44% minus 2.0% or 0.44%. Assuming you have $10,000 in this account for the past 12 months, you would’ve earned $244, but inflation eroded $200 in purchasing power. So your real gain was only $44.
Unfortunately, you’re going to be paying somewhere around 20-30% income taxes on the interest earned, still leaving you with a negative return.
Most savings earn far below 2.44% — probably more like 0.1%. Money in these low-interest accounts would have a Negative Real Return of -1.9%.
Using the example above, your purchasing power went down from $10,000 to $9,981.
The good news is that there are savings accounts that are paying above inflation rate right now, but this could change at any moment. For an emergency fund, you really don’t have much choice. However, this should be a warning not to keep too much cash sitting around because inflation is eating into your purchasing power daily.
What to Do With Extra Cash
Aside from your emergency fund, what should you do with your extra cash? Here are a couple of ideas to make your money work harder:
1. Pay Down Your Debt
Consider paying off high-interest debt (e.g., credit cards, personal loans, car loans, etc.) at an accelerated pace instead of adding money to your savings.
Paying down debt guarantees you a “gain” equal to the finance charges, which are much higher than what you can earn from a savings account.
2. Buy TIPS
Treasury Inflation Protected Securities are the safest investments you can make that guarantee a real rate of return (i.e., positive return after adjusting for inflation).
3. Invest Your Money
One of the reasons why experts advocate investing your money in the stock market is the ability to achieve higher than inflation growth. Over the long-term, the Stock Market has an annualized rate of return of about 9%. This means the Stock Market could provide you with an annualized real return of about 6-7%.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
Other than the buffer I keep in my chequings account, I prefer to invest my money rather than leave it sitting there. This means that I don’t have an emergency account, but I have applied for a low interest line of credit that I will be able to draw on should there be some real emergency. It depends on what kind of insurance you have; people in Asia are known to be heavy savers because there are few government social nets. Over here, there is less of a need to keep so much cash lying around, as long as you… Read more »
i think this is a valid post, but i dont think a cd is a good option at all for an emergency fund. cd’s arent always accesible, thats the idea, you promise not to touch the money for a certain amount of time, hence the higher interest rate. so while i agree that having a big emergency fund isnt the right move (5k+), using cd’s as emergency funds isnt a good idea either! just my two cents on the subject=)
My only issue with this is, what if you are in a real emergency and need to access your money? Chances are it will take awhile to get out of the stock market (and you might take a hit for that). I’m not sure it’s worth that much risk.
@Stephan – there are some penalty-free CD options available. Also, for short-term CDs, an early withdrawal penalty wouldn’t be too bad.
@Jenna – you should keep a small emergency fund that you’re comfortable with. This article talks about negative real return and cited unnecessary large emergency fund as an example. There are also people who keeps a lot of money in savings without investing it.
These are some excellent reminders. It’s really hard to find high yield savings account that’s over 1.5% these days, but even if you do, it still doesn’t keep up with inflation. Some people just don’t like putting money anywhere else due to the risk factor. But still others refuse to put money anywhere other than under their beds…go figure.
Money markets at best typically keep up with inflation after taxes so the real return on them is close to 0. But where else can you put your safe money? Certainly not in your local bank where your real return is almost guaranteed to be less than zero.
Whatever rate you can get from a bank currently, it is a point under inflation, less taxes paid on interest earned. Therefore “thrift” via savings is somewhat foolish…guaranteeing the “thrifty” a loss of buying power each and every year he saves. The Fed, of course, benefits from this as do the big banks who can borrow freshly printed money at the Fed window (and reloan to government at a profit…so they surely don’t need YOUR money, nor do they need to lend). Until this changes, the monetary system is in peril.