No one’s happy with savings account interest rates these days. Even so-called high-yield savings accounts are closer to zero than they have been in a long time. For me, they heyday of savings accounts was when they were earning 5% to 6% APY several years ago. Some people remember when savings accounts earned interest rates in the double digits.
In a world where debt is vilified, habitual savers feel neglected. They played by the rules and now there’s no longer a reward.
An article on Million Dollar Journey includes some reasons why low interest rates are a good thing. First, interest rates need to have inflation taken out of the picture to be meaningful. Rather than the interest rates that banks report, we should look at the spread between the rate of inflation and our interest rate. The higher the spread, with the interest rate being the higher rate, the better off savers are. If inflation is 0.5% when interest rates are 1.5%, the real interest rate is 1.0%. If inflation is 4% and interest rates are 4.5%, the real interest rate is only 0.5%. In this example, the lower interest rate of 1.5% is “better” than the higher interest rate of 4.5%.
This reasoning fails because it relies on the government-reported rate of inflation. Even in today’s low-inflation economy, costs of necessities are rising. The inflation rate may be close to zero, but real costs that people experience are going up. This increase is not going to be covered by bank accounts earning low interest. In theory, purchasing power doesn’t decrease as long as the interest rate stays about inflation, but in practice, that’s rarely the case.
The article also declares that you’re better off earning less interest in a taxable account, such as a savings account, because you’ll owe less tax. This is a crazy argument. It’s the same argument that people use when they say they want to work because hours because they’re afraid of being bumped into the next tax bracket. Almost all the time, more income is still more income.
It’s more tax, too, but not more tax than more income. If you earn $50 in interest, you may owe $10 in tax. You get to keep $40. If you earn $500 in interest, you may owe $100. You get to keep $400. Maybe you’re in a higher tax bracket, and you get to keep only $350. $350 is greater than $40, and therefore, it’s better to earn more money. This is a simplified example, but it’s rare that interest would be the cause of you owing significantly more tax to the government, and you certainly wouldn’t be owing so much that you get to keep less than you could if you had earned only $50 in interest.
The conclusion remains the same: analyze your risk, invest your money appropriately, and buy appreciating assets if they are on sale. Leave only as much as you need liquid in cash. Take the low interest rates for now for any amount of money that you may need to get to quickly. Don’t chase riskier investments just because the rates are low.
If the purpose of an interest-bearing account is to protect your purchasing power, most savings accounts fail on a personal level because the increase in our expenses never seem to follow the official inflation rates.
Published or updated January 6, 2011.
{ 26 comments… read them below or add one }
Fabulous explanation, at what I sometimes assume is common knowledge.
Nicely put. I’ve written about the concept of biflation (inflation in some sectors like food and energy + deflation in others like housing & electronics) numerous times over the past year. The reliance on core inflation is not an accurate measure of the real inflationary pressures out there.
Low rates are good for debtors and bad for savers. Having said that, rates are where they are and we all have to base our financial choices on the reality of the investment climate.
“The inflation rate may be close to zero, but real costs that people experience are going up.”
The CPI is a broad national average. Some costs go up some costs goo down. Individual experiences vary. The CPI is accurate as a national measure of inflation.
Unemployment is 10%. Does that mean that 1 in 10 of my immediate friends must be unemployed or the govrernment is wrong? Of course not. 10% is a national average. Everyones situation will vary. Just like how CPI is a national average and everyones costs will vary.
You misunderstood my point about how a lower tax bill is beneficial.
Of course in the context you mention, making more money is always better, but in my example I show how in REAL terms, in a scenario where the interest rate is similar to the inflation rate, a lower interest rate is preferable in a taxable account.
Why? Because taxes are applied to the gross interest payments – not the “real” interest amount. In a high interest/high inflation scenario, the taxes will increase the difference between the interest payment and the inflation so that you end up with a negative real interest rate. In a low interest scenario, the same effect occurs, but it is less pronounced and you “lose” less to inflation compared to the high interest scenario.
As for the official inflation rate being incorrect – yes, it applies to a basket of items which probably won’t correspond to your lifestyle or my lifestyle or anyone’s lifestyle. However, think about some of the items you might buy – computer equipment, camera equipment, cars – all these items have come down in price over the last 10+ years.
It’s easy to fill up your gas tank every week and think that inflation is out of control, but you have to consider all your spending before coming to a conclusion.
It would be interesting to try to calculate your own inflation indicator, although it might be somewhat pointless, since our lifestyles tend to change over time.
Mike
As Jim said above, the inflation rate is an average. The basket of items that don’t apply to everyone, or apply in a ratio significantly different than the ratio used for the measured CPI. It doesn’t necessarily apply to any one person… but the interest earned on a savings account is tangible and applies personally. The calculation necessary to make the point is partially personally applicable and partially abstract, so there’s no real conclusion that any one person could make without looking at a person’s own inflation indicator.
What you are saying might be true of the spreads in the low/low scenario are the same nominal amount as the high/high scenario. For example, if inflation is 0.4% and interest rates are 0.5% in the low/low scenario and inflation is 4.4% and interest rates are 4.5% in the high/high scenario. Then that spread of 10 basis points is going to be destroyed by taxes in the high/high scenario. But the spreads are really 25% in the low scenario and 2.7% in the high scenario. A more legitimate comparison would be a high scenario of 4.4% for inflation and 5.5% for interest rates — the same 25% spread. Tax would have an equal effect in the low/low scenario as it does in the high/high scenario.
So it all depends on the spread, but I still wouldn’t go so far to say that the low/low scenario is better than any high/high scenario.
Let’s all hope for a world in which inflation is low and saving rates are high. In the mean time, we can take advantage of cheap debt.
The income tax example was just side note – the point of the article was to make investors aware that looking only at nominal rates is not the complete story.
“High nominal rates/low inflation” – I’ll drink to that! :)
Taxes and inflation should always be considered when making investments. In the end what really matters is your return in real dollars. So what you are getting 4% return, if inflation is 4%.
Low saving interest rate makes no difference to me. How much money do you really make from your saving account? I barely made 100 bucks last year from the saving account. Even if the interest rate is higher, I would make only 2 or 300 dollars. This makes no difference in the grand scheme of things. That money is only for emergency. Anything I have over the e fund goes into the investment account.
I just wrote a fairly long response, and had it rejected as ‘a bit spammy’. It’s also been deleted.
IF you want responses, it would help to accept them, mine didn’t have a bit of spam in it.
I’ve just deleted Consumerism commentary from Google reader, maybe temporarily. bad show
I’m not sure why that would have happened. The automated spam system is usually accurate. I don’t see your comment in the spam queue, so I’m not sure what it might have contained that caused it to be flagged. Furthermore, comments that are flagged as spam are kept for me to review just in case… and I have nothing. I’ve sent you an email.
Harm, the SPAM filters are not very smart sometimes. Even big companies like Yahoo can’t get SPAM filters perfect. But the SPAM filter is necessary. Sites like this get literally thousands if not 10’s of thousands of SPAM every year. I’ve had lots of blogs eat my comments or refuse them or simply experience “technical difficulties”. Unfortunately theres no easy solution to all this. All I can recommend is to copy your longer comments into notepad temporarily before you hit submit just to make sure they don’t get lost. I actually do that myself on various blogs since problems with comments are so common.
In the end with inflation is what matters is what inflation you personally experience. The CPI while not totally inaccurate is a tangled mess of calculations and substitutions. From what I’ve seen personally we’ve had inflation in:
– Property taxes
– Tolls
– Mass Transit
– Education
–
– Gas
– Specific foods
As the previous poster has mentioned we’ve seen biflation. We certainly haven’t seen disinflation or deflation. The only real sector that has seen deflation is housing and that was propped up by the government to begin with.
Low savings rates most definitely hurt savers. This again proves our economy (based upon a fractional reserve system) is debt based. IMHO you’ll be a fool not to have some low interest rate debt tied real estate.
The problem is while we may do OK with the current savings and inflation rate, it won’t take much inflation in the future in which savers will get KILLED with their low rate MM accounts and fixed rate CDs. Yes people can transfer into higher rate accounts, but in most cases your purchasing power will be decreasing.
Thank you for the excellent analysis. As a reminder, you do NOT have to settle for 1% savings rates. Higher rate long term CD’s are always available. And if you shop around for those CD’s with the lowest early redemption penalties, you will be able to exit easily if interest rates go back up in the future.
Good point of the spread and real interest rate. What’s the use of 5% interest when inflation is also that much?
Given the explanation you provide for interest rates being low and the tax pros and cons – whether I have to keep my money in such an account is driven by how liquid I need the funds. Yes, higher interest rates can be found and in my tax bracket it doesn’t matter much. But, I need to have my money readily available in case of unexpected lay-offs or medical issues. Why would anybody really choose to keep money at basically zero interest for any other reason than access?
Interesting post and thanks for giving the example in simple math. Hmmm. Something to think about. Regarding Mike’s comment above regarding calculating our own personal inflation, I think it’s easiest to notice at the grocery store. I tend to buy many of the same things – butter, milk, diet soda, same brand of bread, coffee, etc. Thus, although not comprehensive, I’m definitely aware when the price of coffee spikes and doesn’t ever come down, etc. Whereas even a year or 2 ago I could get a bag of beans for $6.99 (regular price) now it’s never less than $9.99 (reg price). That’s not my personal overall inflation rate, of course, and many groceries are only inching up, or even staying the same…but that coffee leap is a huge percentage increase.
I’m in a lower tax bracket so it doesn’t matter much about the interest rate because it might get taxed a little but it doesn’t seem to add much. I have noticed the price of a lot of things going up(or the unit price going up since often they just cut out a bit to save themselves some money). Makes me glad I go to the dollar store for certain things.
I got in on ING when it was at 5%….now we are at a lowly 1.2%…but I am ok with that, it’s still something, and I just use it for quarterly savings (association fees, insurance payments, etc).
I think the tax argument is even dumber than you make it sound, because tax rates are marginal. (I may be wrong about this, I’m not a tax lawyer or accountant, I just remember reading fact checking articles during that whole Joe the Plumber controversy in 2008). That means that you only pay the higher tax rate on anything above the tax bracket line. Say the dividing line is $500 and you pay 10% on anything up to and 20% on anything higher. So if you earn $500, you pay $50 and end up with $450. But if you earn $501, you don’t suddenly have to pay $100.20. You pay the same $50 on the $500, and $.20 on the remaining dollar, so you end up paying $50.20 and are left with $450.20. So you ALWAYS come out ahead if you have more money.
Thanks for interesting thoughts! Low savings rates are not very absorbing for ordinary investors. Obviously we should count with an inflation rate. From my point of view it is not that bad because you still do better for yourself as you are saving and not spending. Anyway I hope that this is just a temporary situation on financial markets.
Great explanation! My thoughts run in the same direction.
This is great advice and for a lot not common knowledge. This will help me and my family. My wife and I have two children and want to save for them but don’t really know how thank you for your help.
Hopefully, the savings rates pick up soon. I keep trying to justify why I’m not putting more towards my student loans when the rates for my savings are so low right now.
I worked at a brokerage firm when interest rates were 6% on money markets – CDs and Bonds were better. Those were the days. I agree it is always better to earn more interest and pay more taxes. Who cares the interest is free money. It is like when mutual funds paid capital gains. Some of my clients would be furious because they had to pay taxes on the money – still the remaining dollars were FREE money. That can be reinvested to make more FREE money.
One has a savings account to save, simple..One does expect a reasonable interest from the bank..who use that money at their own discretion, not always wisely for the saver. The FED is wrong..I remember when interest rates were much higher..every one got along quite nicely, savers and the banks.
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