Savings Account: when to use it and its limitations

Summary:

1. Reviewing the previous step;

2. Getting to the point;

3. When to use a savings account?;

4. Limitations of a savings account;

5. Alternatives to savings accounts;

6. How to choose the best investment?;

7. Conclusion;

8. What's your opinion?

9. Comments section

Reviewing the previous step

In our last post, we talked about Investments for Beginners and highlighted the importance of understanding your investor profile and setting clear goals. Now, let’s discuss one of the most popular financial tools in the United States: the savings account. While widely used, it’s essential to understand its limitations and know when it’s a good choice for your money — and when it’s not.

Getting to the point...

A savings account is a type of bank account that offers monthly interest and is tax-free up to a certain limit. However, the interest rate is often tied to the Federal Funds Rate and follows these general rules:

• When the Federal Funds Rate is low, savings accounts typically offer lower interest rates, often around 0.01% to 0.5% annually.

• Some high-yield savings accounts may offer rates up to 4% or higher, depending on market conditions and the financial institution.

Note: While savings accounts provide security and simplicity, the returns are typically low compared to other investment options. High inflation can erode the real value of your money if it’s only earning minimal interest.

When to use a savings account?

1. Immediate Emergency Fund: A savings account can be useful for small amounts that need to be easily accessible. For example, part of your emergency fund allocated for daily expenses can be kept in a savings account for its liquidity.

2. Avoiding Fees on Transfers: If you don’t have access to other investments with immediate liquidity without fees, a savings account can be an option to avoid extra costs.

Limitations of a savings account

Despite being popular, savings accounts have significant disadvantages and are often considered the least advantageous option for building an emergency fund compared to alternatives like money market accounts or Treasury bills. Their only notable advantage is immediate liquidity, allowing quick access to funds in case of need. However, this liquidity isn’t much different from other options, like money market accounts or short-term Treasury bills, which also offer quick access to invested capital.

• Low Returns: With current interest rates, other fixed-income options, such as Treasury bills or money market funds, provide much better returns.

• Inflation Risk: Savings accounts often fail to keep up with inflation, meaning your purchasing power diminishes over time.

Practical Example: Imagine you have $10,000 in a savings account earning 0.5% annually. After one year, you’d have $10,050. However, if the same amount were invested in Treasury bills yielding 4% annually, the total would be around $10,400. In a money market fund with similar returns, you’d see comparable results. These figures illustrate why savings accounts are not the most efficient choice, even in conservative scenarios.

Alternatives to savings accounts

To maximize your money’s potential, consider alternatives such as:

1. Money Market Accounts:

   • Higher returns compared to standard savings accounts.

   • Federal insurance (up to $250,000 per institution).

   Efficient Strategy: Opt for accounts with competitive interest rates and no monthly fees to combine accessibility and returns.

2. Treasury Bills (T-Bills):

   • Ideal for those seeking safety and simplicity.

   • Returns typically outpace savings accounts, aligning with short-term government bond yields.

   Practical Example: If you invest the same $10,000 in T-Bills for a year at a 4% return, your earnings would total approximately $10,400, depending on prevailing rates.

Note: These are considered the best investments for building an emergency fund. They combine safety, returns, and accessibility to meet immediate needs.

How to choose the best investment?

Ask yourself:

• What is my financial goal?

• When will I need the money?

• Am I willing to learn about new financial products?

Answer these questions and align your choices with your investor profile and goals.

Conclusion

A savings account can be a good option for those seeking simplicity and immediate liquidity, but due to its low returns, it’s worth exploring more advantageous alternatives to grow your savings.

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In our next post, we’ll discuss CDs, MBS and Agricultural Bonds, showing how these fixed-income options can be ideal for those looking to start investing more efficiently.

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What's your opinion?

Comments section