Interest Rates, Savings, and You

If you have been paying attention to interest rates at all, you will have noticed them creeping up rather quickly in the past few months. I have my personal savings at Ally Bank and it seems like we receive an email once a month announcing yet another interest rate increase on our savings account (which, by the way, if you are earning .01% on your savings, do yourself a favor and move that account to an online bank like Ally which is paying 1.90% as of 10/8/2018 on regular savings accounts). I also just glanced at mortgage rates and I see that while I was able to lock in at 3.5% two years ago, rates are now up to close to 5%.

So what’s going on and why?

Well, our economy has been recovering for nearly a decade since the 2008 meltdown and on the whole is in a really good place right now. Without going into key indicators, economic theory, or really fun numbers that you can pull from the Bureau of Labor Statistics--if you think that website is fun, we should seriously get a drink sometime--unemployment is down, corporate profits are up, stock prices are up, and people are spending a little more of their money in the economy (though Gen Y is spending differently than previous generations).

During those lean times back in 2008 the Federal Reserve used one of the primary tools in its Monetary Policy bag, the Discount Rate. In essence, the Fed sets a rate that none of us have access to, so why is it important to us, you ask? Because it is the rate at which banks can borrow from the Fed to meet overnight reserve standards. Okay we may be getting a little deep here, but just know that each bank has to have a certain amount of cash on hand at the end of each business day. If they don’t have that money on hand they can borrow it from the Fed at this rate. This then sets a standard for the banks. They can borrow at that rate (or less if borrowing from another bank), which means if they want to turn a profit on the money they need to do one of two things:

  1. They can offer to loan money to consumers and businesses for more than they pay to borrow it themselves. This way they are earning more interest on the money than they are paying to borrow it.
  2. They can offer to pay consumers a lower interest rate for any savings held at the bank. This is money that they don’t have to borrow from the Fed, and to entice you and I to keep it with them they have to pay us something, but why pay us more than they would pay the Federal Reserve? In fact most banks would prefer to only raise the cash that they loan out through consumer savings because there just isn’t enough savings out there for all the borrowing we as a society want to be able to do.

So as the Fed Funds Rate (Discount Rate) increases, banks are able to (and competitively “have” to) increase their rates. (Notice this hasn’t happened for large banks with their savings rate, and don’t hold your breath for it to either). But if they have to pay back their loans at a higher interest rate, then they will also charge you more to borrow money from them.

Okay, so what does this mean for me?

Interest rates are expected to rise for at least a while longer. A good sign that interest rates aren’t going up more is when the economy looks like it is flattening out. Although you probably won’t be paying attention to those key indicators we glossed over earlier, so when interest rates stop going up that will be your sign that the economy has stopped growing (at least not above the target the Fed has set).

So if you are looking at borrowing money sometime soon, sooner is better than later. Although if you want to boohoo about 5% mortgage rates, don’t do it with someone who bought a home in the 1980’s (my parents got an amazing 12% mortgage rate on their first home!). Similarly, you know that emergency fund that you have set aside with at least 3 to 6 months of expenses? That should be earning at least 1% interest. This isn’t going to make or break your personal finances, but if your $10,000 in savings can earn you $100 in a year instead of $1, why wouldn’t you move your savings account?

But as you can see, earning an extra $100 / year isn’t going to be what helps you retire. So here’s the big question:

How do I give my savings a shot in the arm?

Are you ready for the big secret? Track your spending. It doesn’t have to be to the penny, just get a general sense. And choose something small to cut out. If you go to Starbucks every weekday, trying cutting back to 3 times a week and put the $10 you saved each week into your emergency fund, or once that is filled up your retirement or brokerage account. That’s $520 each year that you would have set aside, quite a bit more than the impact of increasing your savings account interest rate.

Or better yet, finally cut the cord with your cable provider and replace it with Netflix ($11) or if you must have live sports, YouTube TV ($40). I’ve seen people save $200 per month just getting rid of cable channels they never watched in the first place! The trick then is to SAVE the money. As soon as it comes in, put it in your saving account as if you’re paying a bill. This prevents you from viewing that as money available for spending, and you are far more likely to let it sit there and accumulate.

I you want to have a really fun deep dive into the Fed Funds Rate, Monetary Policy, and other fun Economics topics, I suggest you check out the website for the Fed of St. Louis and their FRED system (Federal Reserve Economic Data). The publications are top notch, and the raw data is easier to handle than at the BLS website.