April is Financial Literacy Month, making this a particularly appropriate time to teach young adults about the importance of savings.
Inflation and interest rates are key factors in determining the future value of your savings, so it’s important that you understand their effects. In addition to shopping for higher interest rates for your savings, you can use a variety of investment vehicles to diversify your savings.
Inflation
Inflation is the rise in the price of goods and services over time. Because inflation will reduce the purchasing power of your money, you need a better savings plan than simply keeping your money under a mattress in an inflationary economy. In fact, your savings rate should at least equal the rate of inflation for your money to retain its current buying power.
The average rate of inflation in the United States has been fluctuating between 2% and 4% per year, according to the Consumer Price Index (CPI) from the Bureau of Labor Statistics. Economists usually regard a small inflation rate as desirable since it helps prevent deflation, which is an overall decline in prices. Deflation is usually accompanied by a decline in wages, which occurred with disastrous results during the Great Depression.
The national inflation rate has remained near historic lows since the global recession of 2008. Nevertheless, inflation remains a factor that you need to consider when planning your long-term savings.
Current savings rate
A comparison of your current savings rate with the current inflation rate is an essential step in safeguarding your money from inflation. Certificates of deposit (CDs) are a popular low-risk, fixed-income investment for those wishing to obtain higher savings rates than those offered by bank savings accounts. The best CD rates are comparable, if slightly lagging the current U.S. inflation rate of 2.5% for the 12 months ended January 2020. This means that you’ll need to shop around to find CDs that will allow your savings to keep up with inflation.
As of March 2020, Marcus by Goldman Sachs offered the best rates on CDs among major financial institutions, with an annual percentage yield (APY) of 2.05% for one year, 2.10% for three years, and 2.15% for five years. All of these rates require a minimum deposit of $500. Banks that require a larger minimum deposit typically offer slightly higher rates.
Compound interest
The interest from a savings account is compounded over a specific interval, usually once a year. Compound interest plays a key role in protecting your savings from inflation, so it’s important to understand it. An investment that pays compound interest adds the accrued interest onto the original investment, and that accrued interest also begins accruing interest. Compound interest thus generates interest at an exponential rate rather than a linear one. The more times your money compounds within a certain interval, the more forward momentum your savings will get.
To illustrate the value of compounding, assume for this example that you deposit $100 into a savings account that earns 5% interest each year, compounded annually. (This savings rate is unrealistically high in the current environment but is strictly for purposes of illustration.) This scenario would give you a balance of $105 at the end of the first year. In the second year, you would earn $5.25 based on the same savings rate, yielding a total of $110.25.
Notice that the annual earnings increased slightly during the second year, even though you didn’t deposit any additional money into the account. Under normal circumstances, you would be expected to continue contributing to your savings account on a regular basis as long as you’re earning income, and that money, too, would compound.
While the savings from compounding in the example above is relatively small, keep in mind that the amount invested also was small. When higher amounts are invested, the savings can add up more impressively. This illustration shows the power of compound interest to bolster your savings.
You can calculate your savings at the end of a certain period by using the formula P’ = P (1+r/n)^nt. In this formula, P’ is the savings you’ll have at the end of the savings period. P is the amount you invested at the beginning of the savings period. The variable r is the interest rate expressed as a decimal. In this case, the value of r would be 0.05. The variable n is the number of times the interest is compounded in a compounding period, most often one year.
This value is one for virtually all savings accounts, because most compound interest annually. The variable t is the number of compounding periods (in this case, a compounding period is one year) in an entire savings period that could go on for many years. For most savings accounts, the formula above may thus be simplified to P’ = P (1+r)^t.
Best accounts for savings
Several types of savings tools yield better interest than a standard savings account while still having a level of risk so low that analysts consider them to be risk-free. The best option for short-term savings is usually a CD, which most banks and credit unions offer. CDs are savings accounts that are federally insured, making them very low risk. Their biggest drawback is that they lock up your funds for a specified period of time, so you should buy CDs only with money that you won’t need before the CD expiration date.
Investing in a 401(k) or IRA are typically your best choices for earning returns that will beat inflation over the long term, because they open up your savings to higher-return investment possibilities such as stocks and bonds. Just be aware that these higher-return investments also have higher risks attached, so the potential for losing money will be present. Some low-risk assets that are available in 401(k) and IRA accounts are Treasuries and high-quality corporate and municipal bonds.
Investing in the stock market is riskier than any of the other options, at least in the short term. However, returns on U.S. stocks have averaged about 10% per year over the last century, so the risk is less if you have a long-term savings horizon. Ensure that your portfolio contains a variety of stocks if you do decide to put your savings in the stock market. This diversification strategy will help offset your losses when one of your stocks performs poorly.
Summary
Figure will be providing other educational posts on financial topics during Financial Literacy Month . These posts should be particularly helpful for showing young adults how to make better decisions regarding their money. Figure also provides innovative loan products for borrowers.
