Don’t get me wrong. It's important to save money but don’t make the mistake of parking your funds in a savings account.
The idea of a savings account is simple and from the outside, it seems like a good idea. You park funds and earn money through interest. However, when you start looking at the savings accounts in this day and age, there are some glaring issues.
First, when getting your finances in order it's always good to have a small portion of your net worth in cash. Sort of a rainy-day fund. Or as I like to call it the “when shit hits the fan” fund. This amount should be, at minimum, 5% of your total net worth, but recommend closer to 10%. So, let's say you’re worth $100k, then you should keep about $10k in cash. This is not a hard and fast rule, but it makes sense to me since most of my money is in investments. However, to add to your 5-10% net worth cash pile, you should also keep about 6 months' worth of expenses stashed away. Doing simple math, if you have $5k worth of expenses in a month, you should keep away $30,000 packed away as part of the “when shit hits the fan” fund. Why 6 months and not 3 months. Simple. You never know how bad it's going to get when it gets bad. It's important to make sure you have an honest conversation with yourself and see if that 6-month safety net will be enough or not. For most it should be, if not, up it to 8 months. Personally, I think 12 months is too long.
You’d think, well if I need to have $30k or 6 months' worth of money on the side what’s wrong with putting that money in a savings account.
Savings accounts have some of the worst interest rates available and while the point of having an emergency fund isn’t about amazing Returns on Investments (ROIs), if you’re parking your money you might as well make as much as you possibly can. For example, the average interest rate on a savings account is about 0.05%! That’s awful. And one of the highest interest rates I was able to find was 0.76% from an online bank called Vio Bank. Yeah, I’ve never heard of them either. There is a better option out there, a high yield checking account. On average you are looking at 1.25% interest rates or higher and if you have access to a federal credit union, it could reach even higher than 2%. Let's do some quick math again. If you happen to have $30k stored away at 0.76% you will have $32,280 at the end of the year. If you store $30k in an account that nets 1.25%, you’d have $33,750. That’s $1470 more than you had before. Not enormous gains, but great for money that is literally doing nothing.
From my brief search on the internet, it looks Like Axos Bank is offering an account right now at 1.25% interest with no fees or balance requirements. And since this is a “when shit hits the fan fund” it's also important to have access easily otherwise what is the point of an emergency fund. With some savings accounts, you could be limited to the number of times you can move money in and out, but if you have a debit card, you could make purchases instantly.
Now you may be thinking, well why don’t I just save all my money in a high yield checking account all the time?
The reason is, you’re losing money as time progresses. Whaaat! I know it sounds insane because I just said you’d earn money with interest, but there’s another number that economists love to throw around. Inflation. Inflation is basically a number that calculates the rise in prices of goods and the fall in money’s purchasing value. I’m not going to get in-depth about inflation, but the key metric to remember is the average rate of inflation in the U.S is about 2%. That means you need to earn more than 2% on your money each year to keep ahead of inflation, and if you don’t do that, your money’s purchasing power starts to fall. For example, if you kept $100,000 in cash and earned no interest on it, your $100,000 would not stretch as far today as it did in 2010. In other words, you are losing the purchasing power of what $100,000 can buy. Conclusion: you lost money. Therefore, if you are stocking away large sums of cash and have already filled up an emergency fund, it’s a much better idea to forgo the savings account altogether and start investing your money elsewhere.
My recommendation is, if you want to stay ahead of inflation, the stock market is the place to be. On average you could look at a 7% rate of return every year. That should keep you well ahead of the game. One important reminder: don’t make the mistake of investing your emergency fund in the stock market. The market is a volatile beast and as I said, emergency funds are best when they can be accessed at a moment's notice. You don’t want to be in a situation where you need money for an emergency and the stock market volatility causes stocks to drop when you really need the funds. You could be forced to sell your stocks at a loss.
In short, if you’re building an emergency fund, you’re much better off with a high yield checking account with more access and better rates, because why not choose the better rate anyway. If you are saving for the long term, it is almost insane not to invest your funds in the stock market and stay ahead of inflation.