Today at TILE we talked about what to do when the savings rate (the interest you earn when your money is in a savings account) is less than the inflation rate (the rate by which the cost of things keep rising). It is a dilemma that many investors, including the TILE community, are currently facing. Why is the savings interest rate so low? What is the relationship between inflation and savings? And what can you do to position yourself for the future?
In general, the rates you receive on savings deposits reflect the relationship between the amount the banks are charged to borrow funds and the rate at which they can lend the money. For example, if it costs the bank 1% interest to borrow the funds and they can lend it out at a rate of 4%, their profit (or “spread”) will equal 3%. Try this: if the cost to borrow $100 from your parents is $1 and then you can find a friend who will pay you $4 for using that $100 over a period of time, your profit equals $3. When you account for the risk associated with a loan (will your friend really pay you back on time?), you arrive at the basic explanation for how banks make money.
If you went to the bank to make a deposit in a savings account today, you would probably find the average interest rate on that money to be well less than 2%. While not quite zero, it is definitely a different situation than in the early 90′s, when interest rates could be as high as 9%. So why are the rates so low right now? The government (in the U.S. and elsewhere), in an effort to get the economy moving, is trying to encourage lending by banks and spending by businesses/ consumers – more spending and lending leads to a growing economy. Thus, the bankers at The Federal Reserve have taken the Fed Funds rate (the rate at which banks can borrow from the government) to just 0.5%. This becomes the benchmark by which all other loans are made, and banks only pay you what the Fed says your money is worth. Imagine you were buying an iPod; if you knew the going rate for an iPod Shuffle was $100, there is no way you’d pay $250… right? Thus, based on what it wants to see in the economy, the Fed helps set the tone or the basis for savings rates and lending rates.
So, why is inflation important here? A common occurrence when spending increases is that prices also increase. The best example is what happens to popular holiday toys. If everyone wants the same toy, and the number of units is limited, then prices often go up. If the inflation rate is greater than the rate you earn on your savings, then the purchasing power of that money will be less in the future. For example, let’s say you were saving to buy a really special watch – you put $1,000 in the bank at an interest rate of 1%, so that a year later, you had $1,010 in the bank to spend. Now, over the last year, the price of the watch, impacted by inflation, grew from $1,200 to $1,400. Thus, your money is “worth” less in terms of what you can buy. This is the dilemma.
So what does this mean for the TILE Community? What are some options to consider if you want your money to at least keep up with the pace of inflation? Well, you could consider spending like crazy. But while that might make some companies and the government happy, it may not be the best thing for you long-term. It means you’ll have less savings to tap into in the future, which could make you vulnerable if the economy shifts to a deflationary trend (meaning prices actually fall in the future… so you are feeling kind of silly for spending $1,200 today on a watch that may cost just $1,000 a year from now). Another option to consider is finding investments with higher rates of return. Usually, this means investing in assets that are riskier in nature – greater return but also greater potential for loss. Examples of higher yielding instruments include corporate bonds, high yield bonds, equities, commodities, and other “less liquid” instruments which meaning they are hard to trade in for cash anytime you feel like it. But before you start trading, it is really important to understand your risk tolerance level (taking our Risk Assessment quiz can help with that!) and talk to your banker or advisor about their perspective.
These are complicated times and they bring tough financial decisions home to everyone. But you should know that really smart, experienced people are debating these questions all the time and they don’t have a crystal ball either. So when it comes to your own money, the best thing you can do is know your options… before you make the trade.
- Amy