By Thomas Brennan, CEO of Franc.
A healthy bank account balance means not being in the red for most right? The problem is – that the money sitting in your bank account is doing absolutely nothing for you, in fact with each month that ticks past, you’re actually losing the value of your money over time due to a nasty reality called inflation – the ever increasing cost of living.
So although it might look like a healthy balance now, in a year’s time it’s likely going to be worth about 5% less in real terms. In other words, assuming inflation stays at around 5%, the purchasing power of your bank account balance will be 5% less. This is a worrying thought.
But there is another downside to having a large bank account balance and that is that you’re missing out on earning any real interest on that money. In fact, instead of earning that interest, you’re effectively giving it to your bank. Now that’s an even scarier thought, if we consider the banks are already charging you fees to have an account, withdrawal and deposit fees.
But to understand why you could be losing value in your day to day banking account, it’s important to understand the basics of banking.
How do banks work?
Banks use the money that people deposit and lend a portion of that money out to other people, either as home loans or as personal loans. The bank then collects interest the lenders pay on a monthly basis as revenue for the bank. This revenue is in addition to all the bank fees and charges I mentioned earlier.
The reality is that you could be earning that interest yourself, instead of effectively handing it over to the bank. How do you do that? By investing that money into a money market fund, is using your investment and lending it to banks and other large companies and institutions – ironic, isn’t it.
Either you give the bank your interest, or the banks pay you interest.
What other options do you have?
Money market funds are great for a few reasons, over and above the fact that it pays you an interest rate that is more than almost all bank savings accounts, is that it is as safe and secure as a bank savings account.
Most people save in their bank account for a few reasons: it’s easy and they can access the money in case of emergency.
However, the smarter thing to do is set up an emergency fund of three to six months worth of monthly income in a money market account that still gives you access to your money when you need it but most importantly gives you interest on your savings so that your money can actually grow over time with compound interest.
We generally advise that you shouldn’t have more than 50% of your month’s expenses sitting in your bank account. This is to ensure that you don’t go into overdraft. Once you’ve set up your emergency fund in a money market account, you should be investing for the future, either for retirement or another investment goal that is important to you: like a home loan or your child’s education.
Real Life Example
Let’s imagine you typically spend R6 000 a month on living expenses and therefore only need, at most, R3 000 in your bank account and want a R18 000 emergency fund. Now, let’s say you’re able to save up R10 000 more on top of that R18 000. If you put it into an index-tracking equity fund that grows on average 10% annually and leave it alone for 10 years, you’ll grow that R10 000 into R26 000 – not bad! If you left that money in your bank account you’d likely have about exactly the same amount (R10 000) in 10 years, that’s lost earnings of R16 000! Even if you consider the lost earnings of a savings account with a money market account, you are still looking at lost interest of R4 183 over a 10 year period.
That’s a lot of money that is effectively disappearing.
It is easy to understand why you should be investing and not leaving money in your bank account, because you’re effectively losing money. If you’re investing for the long term you should be investing low-cost index-tracking equity funds that give you a diversified exposure to the equity market.
Don’t forget, when you invest in the stock market, diversification and a long-term horizon are key to ensuring you get the best long-term growth on offer.
Submitted by Franc