I've been plowing through my e-mail lately in my never-ending quest to reach inbox zero. As a result, I've been answering tons of reader questions. And when I can't answer them (or when I think a colleague can do a better job), I try to refer the question to somebody else.
Over the weekend, for example, LP wrote:
I'm a college student and have started saving up and setting aside money, and I feel that the time has come to consider a high-yield savings account, a certificate of deposit, or something similar. It would appear to me that in the time that's passed since you wrote articles on these types of things (and also helpfully comparing some, thank you), the interest rates have dropped from 4-5% on average to 1-2% on average. Why is that? Is it the economy? Should I sign up for interest rates this low, or should I wait and hope that they increase?
Though I understand the basic reasons that interest rates are so low, I decided it made more sense to ask my colleague Richard Barrington to chime in with an authoritative answer. All of the info in the next section is directly from Barrington.
Why interest rates are so low right now
LP has hit the nail on the head: The economy is the reason interest rates are so low right now.
When the economy is weak, people and businesses are less inclined to borrow money. Like anything else, the cost of loans is affected by supply and demand, and low demand for loans means that the cost of loans — the interest rates — has come down.
Adding to this, the Federal Reserve has moved to lower interest rates. These actions range from lending money to banks at extremely low rates to buying bonds on the open market, which drives market interest rates lower. By lowering interest rates, the Fed hopes to stimulate the economy.
Their reasoning is that if loans are cheaper, more people and businesses will borrow, spending will rebound, and the economy will be on its way again. This hasn't worked particularly well, however, because many people are already swamped with debt, and banks have been reluctant to lend money because they got burned in the housing crisis.
So, where does this leave us? According to the FDIC, savings account rates now average 0.19%, money market rates average 0.27%, and 1-year CD rates average 0.68%. However, you can do somewhat better than these rates if you shop around. For example, the best money market rates are up around 1.50%.
One silver lining is that while interest rates are low, inflation has also been quite low; in fact, some economists are talking about deflation rather than inflation in the months ahead. Still, no matter how you slice it, today's interest rates are unusually low. Any decisions you make about those rates should be considered in the context of the fact that these rates are very much out of the ordinary.
Also, your level of optimism about the economy should be a factor. A more robust recovery would increase demand for loans, and would also eliminate the need for the Fed to keep pushing rates lower. In other words, a stronger economic recovery would most likely push interest rates higher.
What should you do with your money?
Thanks to Barrington for taking the time to answer LP's main question. As for LP's secondary question — “Should I sign up for interest rates this low, or should I wait and hope that they increase?” — the answer is: It depends.
My philosophy is that your decision about where to put your money should be less about the potential returns than about your eventual use for the cash. In general, stocks will earn more than bonds, which will earn more than CDs, which will earn more than savings accounts. Not co-incidentally, the higher the potential return, the more risk or drawbacks an investment option has.
All of this is to say: If LP needs his money next year, he probably shouldn't invest it in the stock market. Yes, the long-term average return on stocks is about 10%. But “long-term” is measured in decades. And average is not normal. Those stocks might go up 30% in the next year, or they might drop 50%. If LP needs the money, he should put it somewhere safe, which probably means a CD or a savings account.
No, a CD or a savings account won't give LP the 4% or 5% returns of years gone by. But as Barrington notes in his summary above, those interest rates should be back once the economy improves. The most important thing to understand, though, is that when you're saving for the short-term, high interest is a bonus. What you really want is for your money to stay safe.
What about you? With interest rates so low, where are you putting your cash? Have the low rates prompted you to move your money to the stock market? Have you opted to make major purchases? Or do the interest rates influence your decision at all?
Author: J.D. Roth
In 2006, J.D. founded Get Rich Slowly to document his quest to get out of debt. Over time, he learned how to save and how to invest. Today, he's managed to reach early retirement! He wants to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you reach your goals.