It’s a problem we all wish we had, having too much money in savings. However, although keeping a high balance in a bank savings account might not seem like such a big deal, this is often money that can be earning more elsewhere. The same principle applies to having too much set aside in cash equivalents in your 401k or other investment account.
Is your savings earning enough?
Our advisors often talk about the power of compound interest, but the compounded interest is only powerful if the interest (or growth) rate outpaces inflation.
For example, the default growth rate we use in our retirement plans is 6% or 7%, depending on the client’s equity to fixed income ratio. These are fairly standard rates of return for investment portfolios with moderate to aggressive equity ratios. In contrast, currently the average savings account has an interest rate of .04%, though if you are lucky you may be able to find an interest rate of .5%.1 The below chart demonstrates the difference of investing $1,000, assuming an annual growth rate of 6%, versus keeping $1,000 in a savings account earning .4% interest per year.
Since inflation rates on consumer prices tend to be in the 1 to 3% range each year 2, keeping too much money in a low-interest savings account is like losing money.
How much should you keep in savings?
One of the first steps a person should take for financial well-being is to have saved sufficient funds for an emergency, such as an unexpected major home repair or a job loss. A common rule of thumb is to keep three months (for a household with two full-time incomes) to six months (for a household with one income) of basic living expenses available in an emergency fund. However, you may want to reconsider the form that your emergency fund takes. Here are a couple of options to consider:
- Home Equity Line of Credit: If you own a home and have sufficient equity in your home, one option you may consider in lieu of an emergency fund is a home equity line of credit. Opening a HELOC allows you to borrow against your home’s equity – only when you need to – and pay it back over time – much like a credit card, but with lower interest rates.
- Conservatively invested funds: Another option for an emergency savings account is an investment account with a conservative equity-to-fixed income ratio. While less liquid than a savings account, conservatively invested funds will still typically outpace inflation in their growth and are less prone to market fluctuations as more aggressively invested funds.
If neither of these options appeal to you, or if you prefer the simplicity of a savings account for emergencies, a savings account is always an option, especially if you can find a bank that offers rates above the national average. However, keep an eye on the balance and make sure you aren’t keeping too much in the account.
Another reason you may want to keep some funds in a savings account is if you have foreseeable expenses within the next six months. If you know you will need cash for a major expenditure, keeping the funds liquid in a savings account is safer than keeping it in an investment account, where the funds will be subject to market fluctuations.
Where should you put your savings instead?
Once you have determined your emergency savings ideal balance and location, you get to decide what to do with any excess savings. What you do depends on your individual goals, but here are a few options:
- Pay down high interest debt. If you have high-interest consumer debt, you may even work on paying this down before or while you build up your emergency savings fund.
- Invest for your retirement. Roth IRAs, Traditional IRAs, and non-qualified investment accounts are all options for saving for retirement, in addition to any employer plan you may hold. Each type of account has its limitations, advantages and disadvantages.
- Invest for a short-term goal. A non-qualified investment account is a great option for short- or mid-term savings goals, such as saving for a down payment on a new home, vacations, or home improvements.
Finally, don’t forget to review your employer plan. Make sure your 401k or other employer-provided plan doesn’t have too much allocated to cash or cash equivalents. Sometimes, if you leave the fund allocation to the default selection, this can result in a more conservative fund selection than what it should be for your goals.
As always, your advisors at Financial Plans & Strategies are here to guide you through any questions you may have. If you aren’t sure what your ideal savings balance is, or if you would like to talk through your options for alternatives to savings accounts, please give our office a call at 317-882-7675.