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®.