Since the Federal Reserve cut the short-term interest rate target to near zero in the wake of the Great Financial Crisis, the interest rates banks pay on customer deposits has stayed very low. Even after the rapid interest rate hikes of 2022 and early 2023, the national average interest rate on savings account deposits remained under 0.5%. While there are many reasons to be holding cash instead of investing, it is still important to be cognizant of how your savings are growing and helping work toward your goals. This article will present some additional options for short-term cash holdings that may yield better results than sitting in a bank account.
For many people, having an emergency fund is a critical goal as they build a stable financial life. Being able to tap into a reserve of funds in case of job loss, unexpected expense, or other financial emergency can provide significant peace of mind for day-to-day finances. In addition, other short-term goals might call for keeping funds in cash instead of investing that money for a potentially higher return. Most people are uncomfortable risking funds being saved for specifics goals such as a vacation, home down payment, vehicle, or other big-ticket expense by investing in the stock market and not knowing if their savings will grow or decline in the short term. Putting money into the markets when it will be needed relatively soon for a specific expense is more akin to gambling on short-term market movements than investing. No matter the reason for holding cash, it is still important to be efficient with that cash and not leave money on the table.
One of the primary ways banks make money is called the net interest margin. This margin is the difference between what a bank pays to attract deposits (the interest rates offered to people depositing funds with the bank) and what the bank can earn with those deposits (typically from lending funds out via mortgages, car loans, business loans, personal loans, etc.). When this spread is wide, banks are typically more profitable than when it is narrow. No matter what the interest rate market and yield curve look like, the bank is incentivized to pay as little interest as possible to attract customer deposits, which it can then try to lend out at as high a rate as possible to increase this margin.
It is common to wonder why, if the Federal Reserve increased their short-term target lending rate by over 5% from 2022-2023, why there was not much increase in the interest rates paid by large national banks on savings accounts? The short answer is the big banks don’t need your money. Most people get entangled with their primary bank, having direct deposits, recurring payments, credit cards, debit cards, and more all situated within one account or institution. This hurdle to switch banking relationships, also known as sticky customer deposits, allows major banks to pay paltry interest rates without losing very many customers. A lot of the big-name banks also gathered a large amount of deposits during the Covid stimulus era as well as during the regional banking issues of early 2023. While awash in customer funds that may be hesitant to leave or switch banking options, the largest banks in America do not have much incentive to raise the rates they offer customers in order to attract a larger base of funds from which to lend.
One of the simplest ways to earn more with your cash is to transfer from a basic checking or savings account to a high yield savings account. These accounts carry all the same FDIC insurance as traditional accounts but often pay a much higher-than-average rate of interest. As of this writing, most of these accounts are paying in the neighborhood of 4%-4.5% annual percentage yield (APY), roughly ten times the national average interest rate on traditional savings accounts. Most of these accounts do not have any maintenance fees, transfer fees, or minimum balances and utilizing these is an easy way to increase the earnings on your cash.
Another common approach is to place money for a known goal into a Certificate of Deposit (CD). A CD is a time deposit for a prespecified rate and time period, such as 4% yield for 12 months, that is typically offered by banks to attract deposits (which they can then try to lend out at higher rates). The positives of using a CD include FDIC insurance up to $250,000—similar to a checking/savings/high yield bank account—and locking in a fixed interest rate for the duration of the CD. CDs are commonly used for a specific goal with certain time frame, such as needing to buy a car in six months or wanting to put a down payment on a house in two years. There are even products that allow you to increase your rate during the life of the CD in the event of interest rates increasing significantly. The main downside of the CD is the lack of liquidity, as most of the time you are subject to a penalty of some portion of the interest for cashing it in early.
Lastly, a third option entails investing cash equivalents in a money market fund. These are mutual funds products that must be bought and sold, but the price is almost always $1 so there is little risk of principal loss. While these funds are not FDIC-insured, a money market fund can be considered the next safest place to park short-term funds. Money market fund managers lend to highly-rated companies as well as governments on a very short-term basis. Yields on these funds can be consistently equivalent to and occasionally superior to returns from high yield bank accounts. There are also no liquidity issues as with a CD, as a money market fund can be liquidated and available for withdrawal in one business day.
This article provided some reasons for keeping assets in cash and explained why big banks are so hesitant to increase the interest rates paid to customers, even as rates rose over the past few years. Despite this, there are several options available that allow you to earn actual income on your cash holdings as opposed to seeing your savings get eaten away by inflation and eroding purchasing power in a low-yielding savings account. Please let us know if you have any questions on your specific cash flow management strategy.
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