You'll often hear that there's no such thing as a risk-free investment. And that's largely true. You could buy a stable asset like a bond, only to have the issuer default on its obligation to pay you interest and return the principal you invested.
On the other hand, putting money into a savings account is generally considered to be a risk-free means of earning a profit -- in this case, interest. That's because with a savings account, your principal deposit is guaranteed as long as it doesn't exceed $250,000 (or $500,000 if you have a joint account) and you're banking at an institution that's FDIC-insured.
But believe it or not, savings accounts come with one hidden risk. And the sooner you know about it, the sooner you can take steps to make sure it doesn't hurt you financially.
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When you short yourself on gains
The interest rates savings accounts are paying today are not the norm. And they're also not nearly as high as the stock market's average over the past 50 years, which is a 10% average annual return.
If you put a pile of money into a savings account at an FDIC-insured bank, will you risk losing that principal? Probably not. But you're taking on another risk -- not generating a high enough return to meet your long-term goals.
Let's say you're putting money aside for retirement and by age 30, you have $20,000. You could keep that money in a savings account over the following 35 years. By age 65, you'll have a balance of about $79,000 if your account gives you an average annual return of 4%, which is unlikely (banks have historically paid a much lower rate of interest), but we'll go with it since that's what many accounts are paying today.
On the other hand, let's say you invest that $20,000 at an average annual 10% return over the next 35 years. In that case, you'll be looking at a total of $562,000. That's roughly seven times more income you'd have at your disposal heading into retirement.
Don't just think short-term
When you're setting money aside for a short-term goal, a savings account is generally a better bet than an investment account. The stock market has the potential to swing wildly. And you may need time to ride out a downturn. So if you're saving for a milestone or goal that's five years away or less, keeping your money in the bank is a good bet.
But if you're working toward a long-term goal, whether it's retirement or something else, then you should know that limiting yourself to a savings account might leave you short of where you want to be. So while it's true that your principal deposit may be nice and protected if you keep your money in a savings account, that doesn't mean it's a good idea over the long term.
Instead, figure out how much cash you need for emergency fund purposes, and keep that sum in the bank. You can even pad that figure a bit for an added cushion. But beyond that, consider investing your money rather than sticking to good old cash. Though you'll be taking on some risk, the upside could potentially be huge.
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