Interest Rates: Will They Ever Go Up?
Do you remember a time when your savings account could fetch 4-5% returns a year? Pepperidge Farm remembers. Alas, we live in a bottomed-out interest rate environment. Granny and Gramps are unsure of what to do with their retirement money, because the historical go-to for liquid funds isn’t providing a steady enough return to recoup some of their living expenses. Yikes! Hopefully it’s not too upsetting for the grandparents though; otherwise you may need to have the talk.
Personally, I was predicting a 1-1.25% increase in the Federal Funds Rate (FFR) this year and that might be good news for people looking to put more of their assets into a conservative savings account. Especially since December of last year we’ve seen an uptick of half a percent in the FFR. But don’t get too excited. An increase in the FFR isn’t necessarily a predictor of the market interest rate!
What is the Federal Funds Rate?
For those not in tune with all of the market data and business lingo let me provide a quick summary. The Federal Funds Rate is the rate that the Federal Reserve charges banks for inter-day or short term loans (banks also lend to each other at this rate). If a bank wants to make a loan, and doesn’t have the current deposits, they just ask for a quick loan. The Fed provides!
Currently, the Federal Funds rate sits at .9%, right within the Fed’s projected target of .75-1%. Because we’re on the upper bounds of the target rate, and the economy is still improving, it wouldn’t surprise me to see another bump up at the next Fed meeting. This rate provides a baseline for how banks figure out their market rates because it’s the cheapest place they can find money. The FFR is one of the components of the “prime rate”. The prime rate is the lowest interest rate available in the market – and generally only offered to primo clients. The prime rate can be thought of as a formula. FFR + inflation + Bank A profit premium = prime rate.
Will We Ever See 5% Interest Rates on Savings Again?
To put it simply, I doubt it. That’s not to say interest rates won’t increase. I just don’t believe that interest rates on savings accounts will follow them closely.
Consider the business environment that banks function in today. You must also consider the history of rates on savings accounts. Let’s start with the history. Savings accounts, and the interest paid on them, have always been a marketing tool. Let’s say you and I are banks. I pay 3% on deposits and you pay 4% on deposits. You likely have a higher conversion rate on customer sign-ups than I do. Even today, online banking has surged in popularity because online banks pay 1% interest on savings!
I doubt we ever see inflation topping interest rates though mainly because the business environment has changed. Per an FDIC study done every two years, they estimate the total number of “unbanked” people (people without any transactional account with a bank) to be at 7%. That means 93% of people has some sort of relationship with a bank. The unbanked population in 1989 was near 14%. Banks have a captive audience now. Not only are jobs requiring people to have bank accounts for direct deposit, but it’s simply becoming a prerequisite for life as we move into a more digital lifestyle.
It may also come as a shock to you that interest on savings aren’t required. Like I said, it’s a service the bank provides – it’s marketing and completely optional.
A bank doesn’t need to provide savings anymore because they have other more profitable services to offer. They can sell derivatives, credit cards, structured corporate notes, and much more. A savings account is just a relic from a bygone era.
What to Do Instead of Relying on Interest Rates?
Since I don’t believe interest rates on savings will be going up anytime soon, that leaves a lot of people without options. The general business consensus is that you should buy tangible assets, stocks, or pay down debt when interest rates are low.
Tangible assets would include things like real estate – which can be a very lucrative investment. The reason you buy these types of assets is because they have capital appreciation, and they’re generally expensive meaning you might need a loan. When interest rates are low, that means money is cheap. If you buy a property, which appreciates at 6-10% over the long haul, but you’re only buying money at 3-4% then you’ve got a pretty nice margin there.
The stock market is another thing that benefits from low rate environments as people seek alternative sources of wealth management. This flux of investors causes demand to increase which raises the price of stocks. Plus, since rates are low, these companies are investing in themselves which can be good for returns on revenue – a fundamental indicator of stock health. Furthermore, companies may also look to hand out higher dividends because money is cheap. That can be very good for your bottom line. For reference, the S&P 500 index, over the last 5 years has averaged 13.4% returns a year.
Finally, pay down debt or invest in the market. I’ve written about this before. I don’t usually prefer paying down debt if the asset is appreciating faster than the interest rate. However, depreciating assets like cars, I encourage you to pay off as quickly as possible.
While interest rates may not be raising, or ever raise again, fear not for the average investor! There are a lot of options out there that can pick up the slack. It just takes a savvier investor these days. However, that’s why you’re reading Cash Flow Celt isn’t it? If you take control of your finances, you won’t need to rely on a bank to get you to retirement.
If you need help buying some tangible assets – specifically real estate in Central Florida – you can reach my alter-ego the Real Estate Celt.