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Effective Interest03 02 06 17  22
-------- Risks of a Savings AccountSince we are kids our parents, friends, and specially the financial media is mentoring us to make our money work for us. The first example most people give to us is a bank’s Savings Account or Certificate of Deposit. The whole purpose of making the money work for us is to make it grow, and either let it compound itself on its growing method or produce an income that can sustain or enhance your life without requiring too much effort on your part. People like to use a bank’s Savings Account or Certificate of Deposit because when first looked at, it deceives us into believing there is no risk on it: money for nothing is what people think, you just have to sit back, relax, and enjoy the interests. Reality could be slightly different when you consider things as taxes and inflation. A bank Savings Account or Certificate of Deposit seldom serves you well to ‘make money work for you’. It serves perfectly to hold money at an almost constant value for emergency purposes or for expenses to make in the near future. It is not a vehicle to make money grow or to make it replace a source of income. Let me explain you why. Download the Effective Interest Calculator (Excel Spreadsheet), and continue reading. Almost everyone must have heard a parent, grandparent, or an old guy thinking about his youth and how they could acquire a cold, shapely, glass bottle of Coca Cola for five cents (5c). I still remember how the ugly aluminum cans where sold from automatic machines at fifty cents (50c). Now, you will be hard pressed to find a Coke machine that sells your drink for less than a dollar ($1). If your grandfather had saved his 5 cents under the mattress, he will not be able to buy a Coke can today.Inflation erodes the value of money. We have been lucky to live in a country where inflation is usually around 4%, or maybe even less. Last year it was 3.4%, in part thanks for the ability of Americans to find cheaper sources for their products even when energy prices are constantly expanding. Inflation is commonly calculated using the Consumer Price Index: a basket of products and services that the government has been tracking for a while. The Consumer Price Index doesn’t take into account the ever increasing desire for an even more luxurious life, as most of us have experienced over the past years. Still, it is a good measure and the one I usually use. When a bank offers you 2% of interest, and the consumer price index increase (‘inflation’) is 3.4% that particular year it means that the bank is not even paying you for the depreciation of your money. In a situation like the one described you will still be able to buy 1.4% less of what you where able to buy the year before. When that happens, you may just as well buy everything you want now and save it for later (assuming it is not perishable). And in this article I am not even taking into consideration currency valuations or devaluations with respect to other currencies – specially from those countries which supply the products we are so used to. Remember, I am not talking about money which purpose is to serve as an emergency cushion. I am not talking about the money you will be using on the down payment the house you will buy in two months. I am talking about the money people tell us that ‘should be working for us, not us for it’. Just to add insult to the injury, the taxman (at both, the state and federal levels) will want their portion of the interest paid by the bank. They will want their portion without any consideration whatsoever to the loss you have experienced due to inflation – just when you where believing Uncle Sam was fair you discover this. When the Consumer Price Index Increase (or ‘inflation’) becomes 3.4%, you have to be sure that the after-tax interest paid by the bank is above the inflation. It would mean a bank would have to pay 5 or even 6% depending on your combined tax brackets (state and federal) if you want to see your ‘money work for you’. First of all, you should not despair about these negative statements about Savings Accounts and Certificates of Deposit. Remember, they still have their use as emergency savings and near term money. But for anything above and beyond those to purposes, you may need to find a different instrument. To do so, your first step should be to find out what is the equivalent ‘Effective Interest Rate’ of any interest rate offered by a financial instrument. How you calculate so? I have offered a spreadsheet and a graph that you can download (just adjust your tax brackets and the current inflation rates on the worksheet tab). If you want to do it by hand, it is simple:
The number you end up with is a lot smaller than the one the bank advertises. Even HSBC, Emigrant Direct, and ING Direct may not benefit most people (unless their tax brackets are ultra low). Some people decide to eliminate the issue of taxes, so that the only thing they have to defeat is inflation. Retirement accounts can help you do so. A Roth IRA for example, will eliminate completely the issue of taxes (you contribute taxed money, but the earnings are completely tax free). A traditional IRA or traditional 401k will defer the issue of taxes for later, minimizing it greatly. If you do not feel like deviating from the safety of FDIC Insured accounts, a Roth IRA CD may be your best bet – it will most probably beat inflation and a 0% liability on taxes. Moving to a state with no income taxes also helps: at least you would be saving yourself from one of the taxmen. Once you maximize your tax sheltered accounts you may find yourself looking for other ultra safe options that help you avoid taxes. There are two particular instruments I like:
After a while you notice that even with the super-safe investments I have mentioned before, when you consider inflation you will be making your ‘money work for you’ but at a very lazy and relaxed pace. That is when you discover that there aren’t too many rewards for those who take no risk at all. That is the point when you start looking into Corporate Bonds, Real Estate, Stocks, and others. I have discussed my preferred investment methods in other articles, which I encourage you to read. My main point is that we must start comprehending the effects of taxes and inflations on the money we save before we jump quickly into the false assumption that money is ultra-safe in a Savings Account – it is not, it is a loosing proposition on which it is highly probable that you will have less effective money a year from now than what you put in today. Some of the current high yield savings accounts you may consider:
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