Think fast: Would you rather your savings earned 2% or 5%?
It’s a trick question. It’s impossible to answer without another key fact: the inflation rate. It would be better to earn 2% with inflation at 0% than 5% with inflation at 6%.
It may not give much comfort, but today’s stingy earnings rates on savings look a little better than they did a couple of weeks ago, now that we know inflation is at its lowest level in 44 years. In April, average prices — for everything but food and energy — were a mere 0.9% higher than the previous April.
That doesn’t mean our cash accounts are making us rich. The 12-month CD averages just 0.759%, according to the BankingMyWay.com survey, producing a tiny loss if inflation stays where it is. CDs won’t actually make money on an inflation-adjusted basis, unless you tie your money up for at least two years. The 24-month CD averages 1.207%, the 48-month a princely 1.791% and the 60-month 2.104%.
Does it make sense to tie your money up for five years just to make a “real,” or inflation-adjusted, return of more than 1%? Probably not.
Interest rates are so low they’re more likely to go up than down, though they have yet to go up as many experts had expected a few months ago. For now, bank savings like CDs and money market account should be valued for their safety, not their earning power. You’re probably better off keeping cash in short-term holdings so you can move quickly to something more generous if rates go up.
As a rule, low interest rates are good for borrowers, bad for savers. High rates are bad for borrowers, good for savers.
That makes this a relatively good time to borrow for a new home or to refinance a mortgage. The 30-year fixed-rate mortgage now averages just less than 5%, a terrific deal.
Long-term investors should cheer as low inflation, if it persists, will shore up the buying power of money saved for retirement and other goals. With inflation at 3%, a dollar will be worth only 55 cents in 20 years. At 1% inflation, the dollar would be worth 82 cents in two decades.
So the low inflation figure is good news. But it should not lull investors into a false sense of security. Inflation tends to rise and fall over time, with periods of low inflation offset by periods when it is high. Sometimes it’s very high, such as the double-digit periods in the late 1970s and early 1980s, when borrowers were lucky to get mortgages charging less than 15%.
That means the low-inflation periods should be used to get a little ahead to prepare for high inflation later. Even when overall inflation is low, some costs continue to rise much faster, such as college tuition and health care.
So a long-term plan should assume average inflation of 3%, or even 4% to be safe. Investors should increase the new money they put aside every year by at least that much. In other words, for every $100 you saved last year, you should save at least $103 this year, even though inflation, for the time being, is low.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.