Saving might be a virtue, but it’s not one that the market tends to reward.
Even as interest rates in the economy as a whole have risen over the past few years, savings account interest rates generally haven’t followed suit. Banks are quick to raise rates on things that make them money (such as interest rates on loans), but haven’t been nearly as quick to raise savings account rates.
Simply put, savings accounts are terrible right now.
Ask your parents or grandparents where they keep some of their spare cash, and they might tell you that rather than keep money in savings, they put money into Certificates of Deposit (CDs) or into a Money Market Account. The only problem? Those rates aren’t very good right now, either.
So, is all hope of earning some decent return on your savings lost? What’s the best place to keep your savings? And how much do you really need to keep in your savings accounts?
[This article is one of a fourteen part ongoing series about the way managing your money changes when you get married that will be released from November 2017 to February 2018. But, there’s no need to wait! Click here to download your free Newlywed Money Checklist, that will walk you through each of the steps to take with your finances when you get married. Click the link to get it today!]
You Need to Keep Some Money in Cash
Please don’t misinterpret “Savings accounts are terrible” to mean “You shouldn’t keep any money in savings”. You should.
You need to keep enough money in savings to cover three to six months of living expenses, just in case you lose your job, your car breaks down, or you have unexpected health expenses. There’s no getting around it, you need to have cash that you could access at a moment’s notice.
If both you and your spouse have good paying jobs or your fixed monthly expenses (like your rent or student loan payments) are relatively low, three months of spending is usually sufficient. If your household only has one source of income, or your fixed expenses are relatively high, you should shoot to have six months of spending in a savings account.
Don’t Let That Number Scare You
Three to six months of living expenses is a big number. If you don’t have that much money in savings today, it can seem like an impossible target to reach.
Rather than focusing on the end target, start by working toward something smaller. Instead, calculate your average spending for one month, and focus on saving that much. Once you have that amount in the bank, try to double it. And so on, until you reach your target savings about.
Start small, and focus on saving a month’s worth of expenses at a time.
Once You Have Your Emergency Fund Established, Keep it There
Once you’ve saved three to six months of living expenses, which we call your “emergency fund”, don’t keep adding to it. Leave your emergency fund alone until you need to actually withdraw funds in a pinch. (Of course, once the emergency is over, you’ll want to focus on building up this savings back up to three to six months of living expenses.)
But, you still should check in on this account from time to time. Once or twice a year, you should review your budget to make sure that your spending hasn’t drastically changed. If you’re spending more than you used to, you may need to add some money to your emergency fund, and vice versa.
In fact, most people will need to add to their emergency fund periodically over time. Why?
Because savings accounts are terrible.
Simply put, the stuff we buy tends to get more expensive faster than banks raise interest rates on savings accounts. Long term inflation (the rate that prices rise) is around 3% per year in the US. If the money in your savings account only earns 0.2% interest per year, you’re essentially losing money by keeping money in a savings account.
Which is why it’s so important to review your spending and add to your emergency fund as needed so you could still cover three to six months worth of expenses if you had to.
We’ve talked about why I don’t like savings accounts, but also why you need to use them anyway for your emergency fund. We’ll talk through ways to make the most of savings accounts in a bit.
But what about the rest of your money? Once you have your emergency fund, where should you be putting your savings?
It Depends on When You’re Going to Spend Your Savings
When deciding what to do with your non-emergency savings, the first question you need to answer is, “What’s it for?” Are you saving money for a down payment on a house in a year or two, or for something more long term?
Unfortunately, finding a place for your money that will earn a higher rate of return than savings accounts will involve taking risk. And as a general rule, the sooner you actually need the money, the less risk you should take with it.
For example, I usually recommend that most people in their 20s and 30s invest almost all of their retirement savings in the stock market using low cost mutual funds. These are relatively high-risk investments, but they also produce much higher average expected returns every year. If your retirement account were to drop in value by 20%, you might certainly be upset… but since you aren’t going to retire for several more decades, it wouldn’t be catastrophic since you have plenty of time to earn the money back.
However, if you were planning on using your savings to buy a house a year from today, and your savings were to drop in value by 20%, this would be a much bigger deal for you since you’d have much less time to earn the money back. While long term growth rates in the stock market tend to be good, they can and do fluctuate up and down in the short term.
All of this is a long way of saying: when deciding what to do with money you’ve saved beyond your emergency fund, the primary thing to consider is when you’re going to spend the money. The longer you want to keep the money saved, the more risk you can afford to take.
Some Rules of Thumb
Now that we’ve discussed how to think about risk with the money you have saved, consider the following options for your short and longer-term savings. There are pros and cons to each of these strategies that you should consider before making a decision- if you have any questions about these strategies, shoot me an email.
Short Term Savings (You Expect to Spend the Money in 0 – 2 Years)
For short term savings, you should take as little risk as possible to minimize your risk of loss in the account. If you’re still up to take some risk, you might consider investing 20% of your short-term savings into stock mutual funds, and the other 80% into bond mutual funds. This portfolio mix will still fluctuate with the market, but it should offer you a decent expected long run return.
Better yet, you might consider only investing in bond mutual funds and skipping the stock component altogether. Bond funds still go up and down in value like stocks, but tend to be less volatile in most environments. A money market mutual fund could also work well, but will offer a lower expected return (in exchange for less volatility).
If you’re looking for places to put your money that don’t pose a substantial threat to drop in value, you could consider a short term individual savings bond or a CD that matures by the time you need to withdraw the money. While rates on these vehicles tend to be relatively low, they are still a safe place to put your savings. And particularly for 2 year CDs, rates tend to be much better than you’ll get on a savings account. But, beware: using either of these investment option, you’re tying your money up for the full term of the bond or CD. If you buy a 2 year CD, you shouldn’t plan on taking the money out of the CD until the full two years are up.
Finally, particularly if you are looking to use your money in the next few months, you may be stuck keeping your savings in cash. We’ll talk about ways to improve your returns on these types of funds shortly.
Medium and Long-Term Savings Goals
While any of the short-term strategies I described above could be used for longer term savings goals, I recommend investing your longer-term money into stock and bond mutual funds. A longer-term CD or individual bond could work for you, but you’ll likely be better off putting your money into the market.
Since stock mutual funds offer more risk and more reward than bond funds, the longer you are looking to invest for, the higher the percentage of your investments should be in stock funds.
For example, if you are looking to buy a house in five years, you might consider investing 50% of your money for this goal into stock mutual funds, and 50% of your money into bond funds. If you’re looking to invest for your newborn child’s college education, you might invest 80% of your savings into stock mutual funds, and 20% into bond funds. And if you’re saving for your retirement that’s 35 years away, you might invest 100% of your retirement savings into stocks.
One final note about this, though. As you get closer and closer to realizing these longer-term goals, you want to make sure that you gradually shift your investments into more conservative positions, all else being equal. If you want to buy a house five years from now and you decide to invest your savings 50/50 in stocks and bonds, as you get closer to the point in time when you want to buy a house, you should shift your account away from the stock funds and into more bond funds or CDs.
This is All Well and Good, but Where Do I Keep My Cash?
You know the options for where to put your savings beyond your emergency fund, but that still leaves us with the same fundamental problem we had at the beginning.
If savings accounts are terrible, is there another option for where we can keep our emergency fund and maybe even our savings for our short-term savings goals?
The answer is, “sort of”.
Ditch the Traditional Savings Account and Open a High Yield Savings Account
Like just about everything else in our lives, the internet has drastically altered the landscape of personal finance options. A few decades ago, you would have needed to work with a stockbroker to invest in a stock or mutual fund. Now, you can open up an account at TD Ameritrade and place a trade on your own with just a few clicks of a button.
The same thing has happened with savings accounts. A few years ago, you had no other option than to keep your savings with the local branch of a national bank, or maybe a more regional bank or credit union.
Over the past decade, several banks have opened high yield savings accounts. These aren’t banks that you could go to visit in person; instead, they operate 100% online as a way to keep their costs low. This, in turn, allows them to pay significantly higher interest rates than the traditional savings banks.
Three of my favorite high yield savings accounts are
As of this writing, all three of these banks paid the same interest rate and they have been regularly raising their rates over the past few years. They also have no monthly fees associated with them, and are FDIC insured.
Best yet, the interest rate on these accounts is literally over 4,000% higher than the interest rate paid on a Bank of America savings account at the time of this writing.
Most savings accounts just aren’t good in today’s interest rate environment. And even with high yield savings accounts, I still don’t recommend keeping your medium- and long-term savings in one of these accounts.
But, if you’re looking to get a higher return on your emergency fund and even your short-term goal savings, a high yield savings account is the first place I’d start.