With interest rates on saving accounts once again at rock bottom levels, some savers are looking for alternatives. But in the context of a long-term financial plan, does it really matter?
Obviously, you want to earn as high a rate as possible on a FDIC insured savings account that provides full and instant liquidity. Bankrate.com provides a list of some of the highest rates available for both online savings accounts and CDs. As of right now, the best offers are in the 0.5-0.6% range
But even when you seek out the highest rate, after taxes and inflation, you will end up with less purchasing power than you started with. This is unfortunate and is almost always the case. However, the value of a savings account goes well beyond the interest earned on those funds.
“The first rule of compounding is to never interrupt it unnecessarily”. – Charlie Munger
The purpose of a savings account is to provide a buffer between your short-term needs, both expected and unexpected, and your long-term investments. The ability to have access to cash when it is most needed allows you to stay invested and avoid selling your investments, perhaps when stock prices are at a low point and prospective returns are at their highest.
For example, it is early March 2020 and Jim is a manager in the restaurant business. He participates in his employer’s 401K where he invests in a diversified portfolio heavily weighted toward stocks. In addition, he has built up a substantial balance in an online savings account earning less than 1% per year.
Then, suddenly, he is furloughed due to the COVID-19 pandemic, and his paycheck is stopped. He has no choice but to live off his savings.
Because of the funds available in his savings account, he can leave his 401K investments untouched. As a result, over the next 14 months, his 401K assets increased in value by more than 50%!
Did it really matter that he was only earning 1% on his savings account? Not at all! You could argue that the “return” on his saving account was 50%, because it allowed him to stay invested and participate in the remarkable 2020-2021 market rebound.
Therefore, our suggestion is to not get frustrated with the miniscule return on your savings accounts. Instead, remember the role that a savings account plays in your long-term plan. By acting as a buffer between your short-term needs and your long-term investments, a savings account, even one that is paying minimal interest, will provide ample returns by allowing you to leave your long-term investments untouched, compounding year after year, uninterrupted.