Why Savings Accounts – And Why Not

Over the weekend in a post answering anonymous reader questions, I wrote the following:

Savings accounts are wonderful places to keep money that is very liquid (meaning you can get it if you need it) and earns a small rate of return with very little risk. Because of these factors (liquid, low risk, some return), they are great places to store emergency funds, which is a fundamental part of any personal finance strategy. An emergency fund is a buffer to prevent budgetary disaster in the event of a personal crisis.

This inspired the following question from a very faithful reader who sent me an IM less than five minutes after that article was posted:

It seems to me like it is always good to put your money in a savings account that earns 5% like HSBC Direct. Why would you do anything different?

As I mention, there are indeed a lot of advantages to savings accounts. You can get at the money at your convenience, it can make a nice return in the right account (HSBC Direct, for instance, has a 5.05% APY and some smaller banks do better than that), and there’s very little risk as the account is insured by the FDIC up to $100,000. It is without a doubt a stellar place to put your cash that you may need in the short term.

However, once your savings reaches a point that is out of the reach of your emergency fund needs (at least a few months’ worth of salary), it’s time to start looking for a place to put your money for the long term. For example, the Vanguard 500 has returned an average of 12% a year since 1976, but that return isn’t guaranteed year in and year out – some years have had a net loss, while others have had returns far above 12%. It’s still reasonably liquid in there, but you can pull out at any time (we’ll not get into the taxes on your gains here, but at most you’ll have to pay the same rate as your normal income and it may be substantially less than that). There are many real estate investments that can return spectacularly, too.

Why do this? The potential returns are too good to pass up. If the Vanguard 500 continues along at the historical rate, the money in it doubles every six years, while in a 5% savings account, your money doubles roughly every sixteen years. Let’s say you put a dollar into the savings account and a dollar into the Vanguard 500 and waited 20 years. The savings account would have $2.65 in it, but the Vanguard fund (if it continues at the historical rate) would have $9.65 in it. Multiply those by a thousand or ten thousand and you’ll see why it’s a big deal.

So why not just invest everything in the Vanguard 500 or another investment if it returns that kind of money? The reason is that it’s not insured and it’s far from a guaranteed return. There have been many years where the Vanguard 500 has lost fistfuls of money (the returns from 2000-2002 were positively nightmarish, with 20% losses) – the positive numbers are only over the long term because the good years overall outweigh the bad. On the other hand, a savings account won’t lose its value – it will just stay there and chug along quietly for you, keeping your money quite safe for you.

In other words, keep enough in the savings account so that your short term needs and emergencies can be met, then take the rest and play with it for the long term by investing it somewhere.

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  1. Tkriger says:

    Good advice…

    I just recently passed $1,000 in my E-Fund, and am now planning on paying down the ~15,000 in student, credit and car loan debt I have. I am still planning on putting about $100 a month to grow the E-Fund eventually to 3 months worth, but for now its not a priority…I can’t wait till I have enough in there to start investing in non-retirement accounts.

  2. Ted Valentine says:

    This post is sorely incomplete financial advice. Assuming you’re out of debt except your 1st mortgage, you should maximize all of your pre-tax savings (401k) and fully fund a Roth IRA before dabbling with non-retirement mutual funds.

    Many would even say that paying off your mortgage early would be the better investment. Compare a guaranteed 6% rate of return on paying the mortgage off to a risk- and tax-adjusted rate of return on the S&P 500 and you’re looking about dead even.

  3. John says:

    FDIC Insurance is not the perfect solution we all rely on it. If I remember correctly they have 20 years to pay back that 100,000$ (with no penalty or interest during that time) and the reality is that if HSBC or Bank of America etc failed and the FDIC had to step in serious problems would exist in the economy and the Fed’s ability to pay out would be highly suspect.

  4. I never understood why some people recommend a money market account over a checking account. From what I gather, they seem to have almost the same return, if you find a decent online savings account.

  5. Rick says:

    Ted Valentine: I don’t see anywhere where Trent said this is all the financial advice you’ll ever need. This post, as well as all his posts, constitute just one piece of the puzzle. He states, “they are great places to store emergency funds, which is a fundamental part of any personal finance strategy.” Note the part “fundamental part”.

    Further, there are quite valid reasons why one may not wish to put all his money in retirement accounts. What if he wishes to retire early, but his retirement accounts are locked (or at least, access to them incurs a penalty)? What if he is saving for a vacation in five years? What if he’s saving for a new car? A boat? Good luck using your retirement account for any of these activities.

  6. Trent Trent says:

    Ted, read the last sentence of the article again. Carefully.

  7. Your example of how things double gets even more exaggerated when inflation is factored in. At 3% inflation that savings account only makes 2% meaning that it would 36 years to double in terms of real spendable money. However, in the Vanguard S&P 500 at 9% after inflation, it doubles in 8 years, about 4.5 times quicker.

  8. Ted Valentine says:

    Rick – All said is it was incomplete — and potentially misleading. You add a perspective that wasn’t in the post. You seem to agree.

    Trent – I read the last sentence carefully the first time and again just now. I still think its incomplete and potentially misleading advice.

  9. Maryanne says:

    Regarding on-line savings accounts. It’s not as liquid as I thought.I want to buy a car today, so last night, I easily transferred some $ out of my ING savings account back into my original bricks and mortar checking acct. Note comes up that funds take 2-3 business days to actually transfer. Oh great – what do I do today? Then, I went to my HSBC account to do the same thing -transfer money out of that account back into the original checking used to open the HSBC account. Well, it’s even less flexible than ING. For me to do that, HSBC requested my ID name AND password for my bricks and mortar acct!!!! I thought banks would never ask you for that info but that’s what HSBC insists on. That is ridiculous – I already opened the account using my checking account which you spent days verifying with the small amount deposits. Why do I have to do that all over again or give you all of my most personal info to my checking account!Geesh! Again, ING is the more flexible of the 2 accounts. Learn from my bad experience – online savings account are for savings only – it’s very difficult to withdraw $

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