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.