The answer may surprise you.
- The Federal Reserve raised interest rates by half a percentage point on Wednesday.
- This is likely to result in a small increase in savings account returns.
- It does not necessarily mean that it is advisable to spend much more money on savings.
On Wednesday, May 4, 2022, the Federal Reserve raised the federal funds rate the most since 2000.
In an ongoing effort to combat decades of high inflation, the Federal Reserve has raised rates by half a percentage point. This followed an earlier rate hike in mid-March and the benchmark rate is now 0.75% to 1.00%, up from 0% during the heart of the COVID-19 pandemic.
With the increase in the federal funds rate, banks are expected to raise interest rates on savings accounts. But does that mean you should spend more money on savings?
Do higher savings account rates justify higher investments?
When the Fed raised rates by 25 basis points in mid-March, it had an undeniable impact on savings account rates. Specifically, the average yield offered by high-yield online savings accounts has risen four basis points. Given that the rate hike is more substantial this time around, it is likely that the APY of savings accounts will also go up a bit more than after the last rate hike.
However, although savings accounts increased after the last rate increase, average yields remained at only 0.54%. Needless to say, this means you won’t see a very impressive ROI in any money you put into saving.
Unfortunately, the Fed has been pushed to raise rates to fight record inflation. Prices rose 8.5% year-on-year until March 2022, which meant that goods and services cost substantially more last March than the previous year.
With inflation at 8.5% and typical savings account yields still well below 1%, the money you have in savings is not keeping up with rising prices and your purchasing power is eroding. That won’t change, even if rates go up.
As a result, increasing the amount you invest in savings accounts doesn’t make sense just because rates will go up slightly.
The amount you have in savings should be dictated by your financial goals
Ultimately, you should not put money in a savings account because of the returns you can get. You have to put your money into savings because you need the money to be in a liquid state and in a risk-free investment.
It is important to keep certain types of money in savings. For example, you want your emergency fund money to be in a savings account so you can easily access it when you need it. And if you are saving money you will need in the coming years, you should also be saving. This way, you can access it when you need it without having to worry about trying to time your withdrawals based on financial conditions.
The amount of money you will need to save for emergencies and for these short-term financial goals is dictated by your financial goals. In other words, it’s a good idea to spend three to six months on an emergency account. And if you need to save to pay an advance to buy a house in two years, you will want to deposit in your account everything you need.
However, the money you expect to invest for long-term goals should be in the stock market or in other assets that are likely to yield much higher returns than a savings account. And that doesn’t change just because savings account rates are up slightly.
You still need to keep exactly as much money in savings as you need for short- and medium-term financial goals. Put the rest in the market where, hopefully, you can get the kind of returns that will not only keep pace with inflation, but also allow you to create wealth.
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