What Low-Yield Cash Really Costs

Most people check whether their savings balance went up. Fewer check whether it can still buy as much as it could a year ago. Cash in an account that pays almost nothing feels safe, and it is safe from a market crash, but it is not safe from rising prices or from the quiet gap between what your bank pays and what the same money could earn a few clicks away. This chapter measures both costs, explains why the gap exists, and sets up the idea the rest of the book is built on: every dollar of cash should have a job, and the job decides where it belongs.

Two numbers on every balance

A savings account has two rates that matter, and the statement shows only one of them.

The first is the nominal rate, the annual percentage yield (APY) the bank pays. The second is inflation, the rate at which prices rise. What your savings can actually buy grows at the difference between them, called the real return. The exact version is the Fisher equation: real return = (1 + nominal rate) ÷ (1 + inflation) − 1. When the account pays less than inflation, the real return is negative. The balance goes up and the purchasing power goes down at the same time.

Here is a cash reserve left in a low-rate account for five years, first as the statement shows it and then in today's dollars, assuming prices rise 3% a year.

The statement says $20,403. In today's prices that balance buys about what $17,600 buys now. Nothing went wrong with the bank and no money was withdrawn, yet roughly an eighth of the reserve's buying power is gone.

Now the same reserve at a rate that roughly keeps pace with prices:

At 4% the reserve ends the five years worth about $20,990 in today's money. It is not a large gain, and it is not meant to be. The point of cash is to be there, at full strength, when you need it. A competitive rate is what keeps it at full strength.

The real return calculator runs this for any rate, inflation assumption and horizon.

Why the gap between banks lasts

If one bank pays a fraction of a percent and another pays several percent on the same kind of insured deposit, why does anyone stay with the first one? Two reasons, and both are worth understanding because they tell you the gap will not close by itself.

Banks earn the spread. A bank takes deposits and lends them out or buys securities with them. Its profit on that is the difference between what it earns on the money and what it pays you, a figure banks report as the net interest margin. Every tenth of a point not paid to depositors stays with the bank.

Most depositors never move. Savings tend to stay where they were first opened, next to the checking account, even when another insured account pays far more. Switching takes an afternoon, and most people never find the afternoon. A bank with a big base of customers who keep their savings next to their checking account out of habit has little reason to compete on rate. Banks that need to attract new money, often online banks without branches to pay for, compete hard. The same institution sometimes runs both kinds of account under different brand names.

The Federal Deposit Insurance Corporation publishes the national average rate on savings accounts each month (see the sources for this chapter). That average has for years sat far below what competitive accounts pay. If your account pays close to the national average, you are likely being paid for inertia rather than for your money.

What the gap costs over time

The loss from a low rate grows with the balance and with time. A household that adds a fixed amount to savings every month shows it clearly.

Both savers put in $60,000. At the low rate, interest adds $1,204 over the decade. At the competitive rate it adds $13,348. The only difference is the account the money sat in, and moving it is a one-time chore.

These examples hold the rate steady, which real rates never do. Savings rates follow the Federal Reserve's policy rate up and down, sometimes within months. What tends to stay steady is the gap: accounts that pay well when rates are high usually still pay well when rates are low, and the reverse.

The wrong comparison: cash against the stock market

Many articles on this subject compare a savings account with a stock index fund and conclude that cash is a waste. That comparison mixes up two different jobs.

Cash held for emergencies, for bills due in the next few months, or for a purchase with a date attached has one requirement above all: it must be there in full on the day you need it. Stocks can fall by a third or more in a year and take years to recover. Money that has to be available on a date cannot take that risk, so the fair comparison for it is the best safe rate, not the stock market.

Money you will not need for many years is a different question. Holding it in cash for decades does carry a real cost, and the Investing shelf of the Library covers that decision. The mistake to avoid runs in both directions: long-term money sitting idle in savings, and emergency money invested in assets that can fall just when you need them.

Give every dollar of cash a job

The rest of this book is organised around one simple sorting step. Before choosing an account, decide what each part of your cash is for:

• Spending money: this month's and next month's bills. It belongs in checking, where it is instantly available. Rate barely matters because the balance is small and keeps moving.
• The safety reserve: an emergency fund sized in months of essential spending. It needs to be reachable within a day or two and insured. High-yield savings accounts and money market options (chapters 2 and 3) fit here.
• Money with a date: a tax bill, tuition, a down payment, a car. Because you know when you will need it, you can lock in a rate until then with CDs or Treasury bills (chapters 4 and 5).
• Long-term money: anything you will not touch for five years or more. That is usually investing territory, not cash.

Once each slice has a job, the right home for it is usually obvious, and the remaining choices come down to rate, access, insurance and tax, which chapters 2 to 6 work through. Chapter 7 puts it together into a system that runs on its own.