Why Savings Accounts Lose Money

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There’s one rule about money that most financial experts would agree with: Pay yourself first. This means that, once you’ve gotten a paycheck and are deciding what to do with it – after you’ve paid your rent or mortgage payment and other necessities, of course – you should “pay yourself” before deciding to spend your money on anything else.

There are many different variations of what this means. But for most people, paying yourself means depositing money into your savings account – one you’ve set up to help yourself set up a nice nest egg, to have on hand for an emergency or an upcoming major life purchase.

The Importance of Savings Accounts

The importance of putting savings towards an emergency fund cannot be overstated. It’s vital to have funds readily available to you in case the unthinkable happens. (Most experts would recommend you keep 3-6 months’ worth of expenses in your emergency fund.)

Savings accounts are also good for when you’re saving up for a big purchase in the relatively near future – a big vacation, say, or a down payment on your first home. However, when saving for the long term, keeping the majority of your savings in a traditional savings account could actually make you lose money. Let’s take a closer look at why.

Compound Interest

By now, you have probably heard all about compound interest – the idea that an amount you invest could continue growing as earned interest is rolled back. So, if you deposit $100 in a savings account that is compounded annually and earns back 1% a year, at the end of one year, the account will have $101. After two years compounding at the same rate, your account will have $102.01, and so on.

At the end of 20 years, your initial $100 in savings will have only grown to $122.02. Now, that is provided you don’t make any other contributions – which, of course, you should. If you add an additional $100 to the account each year, at the end of 20 years, you’ll have $2,345.94 in the account. (To make these calculations easier, we recommend using an online compounding interest calculator, like this one.)

Inflation vs. Savings Accounts

So what we’ve learned is that the money you continue saving each year sits in the same place, and you continue growing your wealth without doing much, right? Not exactly.

Because of inflation, the $100 you invest today will be worth a lot less in 10 or 20 years. You’ve likely heard your parents or grandparents talk about how a soda used to cost a dime, or how a very nice home only cost $30,000 in the 1960s. That’s all because of inflation – because prices increase over time, a dollar just simply doesn’t buy as much as it used to, meaning it is worth less.

Let’s say that inflation rate steadily stays 3% a year for the next 20 years. That means that, in 20 years, $100 would only be worth $54.38 in today’s money. If you made a one-time investment of $100 into a savings account like in our example above, inflation could reduce your investment from $122 to being worth only $68.

And keep in mind, 1% is a generous interest rate for a savings account. The average annual percentage yield is only 0.06%.

Savings Account Alternatives

So what can you do? Instead of keeping your money in a savings account for long-term growth, you should look into your options for investing. It is generally expected for you to receive a 7% annual return by investing in stocks.

Let’s say you took that initial $100 and invested it in stocks instead of putting it in a savings account. Without accounting for inflation, that $100 would grow to $387 after 20 years of being compounded at 7% annually. With a 3% annual inflation rate, it would be reduced to $214. While that’s considerably less than it would be worth without inflation, it’s much more than the amount you’d be left with after keeping your money in savings all that time.

Of course, it’s important to know the risks associated with investing. Diversification is an important technique in lowering the risk of your investment portfolio, which we’ll discuss in posts to come.

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Why Savings Accounts Loose Money

There’s one rule about money that most financial experts would agree with: Pay yourself first. This means that, once you’ve gotten a paycheck and are deciding what to do with it – after you’ve paid your rent or mortgage payment and other necessities, of course – you should “pay yourself” before deciding to spend your money on anything else.

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