How to Earn a Good Interest Rate in a Low-Rate Environment

Tara Struyk — Thu, 03 Nov 2011 10:24:10 +0000

I recently wrote an article where I explained two basic financial tips that had helped me stay on track with my finances. It was pretty basic advice, but the email I got from readers was dominated by questions and remarks about my decision to use a 6% interest rate to calculate the potential return on monthly savings of $200. Just how, many people asked, do you propose I get a 6% return? The question underlies a fundamental misunderstanding about a key concept in finance — average returns. If you’re struggling to find a way to earn some interest in this ultra-low interest rate environment, read on to learn why 6% isn’t an unreasonable expectation, even now. (See also: 7 Banks Still Offering Great Interest Rates)

How Interest Rates Work

Right now, savers are lucky if they can find a savings account that yields more than a 1% return. That’s because the interest rate you receive in a savings account is determined by the rates set by the U.S. Federal Reserve. Right now, the benchmark interest rate (which represents the lowest interest rate that investors will accept on non-Treasury securities) is currently at a historic low of .25%. However, between 1971 and 2010, interest rates averaged 6.45%. In fact, in the 1980s, those who bought certificates of deposit got rates as high as 14%!

While we’re unlikely to see returns like those any time soon, rates fluctuate over time based on a number of factors. And, because the benchmark rate can’t fall much lower, it’s going to have to head back up at some point. So even if returns are pretty paltry in most low-risk investments right now, this doesn’t mean your average rate over time will be anywhere near as low as the returns you're getting right now. However, your odds are even better if you invest that money rather than save it.

Saving Versus Investing

If you understand how averaging works, you can see how your return over many years may be much different from the rate you are currently getting on your savings. However, while a savings account is a must in case short-term financial needs arise, larger amounts of cash should be invested. If you’re looking to maximize returns, a savings account isn’t the best place to park any funds you don’t need to withdraw in the near future. If you’re looking to earn more on your money, consider an index fund, mutual fund, or even a well-tended stock portfolio. You could lose money in these types of investments, so if you're not a pro, you should use them sparingly and consult a financial advisor. However, it's risk that dictates your potential for return; adding just a little to your portfolio can drastically increase your chances of a better return. And, just as in saving, time is a big factor. For example, if you stick that money in an S&P 500 index fund, you have a 55% chance of earning 10% in one year. Keep the money in for 10 years, and your odds are closer to 85%.

The Key to Better Returns

The key for investors and savers is not to worry so much about what the rate is right now, but to set up a habit of saving consistently and keeping that money invested. If people save and invest consistently over time, they will be able to maximize returns and minimize risk. So, just as past performance doesn’t indicate future returns, current returns don’t dictate your average return over time. When it comes to money, time is one of the most important factors; returns may be poor right now, but if you stay the course, you are likely to get a chance to make up for those low returns down the road.

This article is from Tara Struyk of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Quiet Millionaire: Part 3 - Money for Now, Money for Later

Julie Rains — Wed, 07 Nov 2007 19:28:55 +0000

You've figured out how to have positive cash flow (aka spend less than you earn) for now; but will you have enough money for later? Funding for future requirements, such as retirement, is crucial to financial success, according to The Quiet Millionaire author Brett Wilder. He states:

"...while you may not be having a current cash flow problem paying your bills, you may have a future cash flow problem without even knowing it by not saving enough for future obligations."

So how much do you need to save? I’ve created a Funding for Retirement spreadsheet (downloadable, customizable in Excel) and Q&A guide that will help you find out.

SPREADSHEET Q&A

What does "Funding for Retirement" do?

It helps you figure out how much money you’ll need to save for retirement based on a set of assumptions.

What are assumptions?

They are educated guesses about the future based on what you’ve experienced in the past or think is likely about the future. For the spreadsheet to be useful, you’ve got to make some reasonable assumptions, such as:

Projected Annual Needs: $70,000
Annual Growth of Investments: 10%
Conserve Rate: 5%
Inflation Rate: 2%

What is the "conserve" rate?

It's the investment rate you'll likely earn after you've retired, when you want to conserve your assets.

How do I use the spreadsheet?

Enter the following values into bolded cells:

Projected Annual Needs
Investment Growth Rate
Conserve Rate
Inflation Rate
Your Age Now
Your Age at Retirement
Your Balance Now

Everything else is calculated for you. The most relevant number is the PAYMENT needed TO REACH your targeted BALANCE.

The schedules are just for fun. They show 1) how your investments will grow over time and 2) how you will use your investments in retirement. I put them together to check my calculations.

Can "Funding for Retirement" help guide my financial planning?

Yes, but mainly it is a tool to give you an idea of how much you should be saving each year. And, you can play "what if" by changing assumptions (see how investment rates can dramatically change annual payments needed, how one or two more years of working can help build your assets, etc.).

In the spreadsheet example, if you are 30 years old, plan to retire at age 65, have saved $20,000, think you will earn 10% each year while saving for retirement and 5% each year while conserving your investments, project annual inflation at 2%, and need $70,000 per year (in today's dollars) to live, then you'll need to save $8,241 per year. Using a "what if" scenario, if you grow your investments 12% per year, then you'll need to save $3,923 per year; 15% growth will require only $20.

What if I will be getting a pension or Social Security payments?

You can adjust Projected Annual Needs to reflect your additional needs only (projected annual needs less annual pension or Social Security income).

Why doesn't the spreadsheet have a place for taxes?

A few reasons:

If you funded your retirement using a Roth account (consult your tax pro for more on income and annual contribution restrictions), you won't have to pay taxes when you withdraw your money.
You can add taxes to your Projected Annual Needs -- use the following formula: Projected Annual Needs/(1-Tax Rate); as an illustration, if your Projected Annual Needs = $70,000 and your effective tax rate is 20%, then you will need $87,500 to support your planned lifestyle.
I'll be discussing Mr. Wilder's insightful ideas on tax planning for retirement in a separate post.

Will my investments earn 10% every year for 30+ years?

Probably not. Some years, you may earn more; some years, less. Still, you can get a general idea of how investment growth will impact your portfolio value.

What is cool about this spreadsheet?

You can change the assumptions and update it every year if you'd like. Also, you can download it for free!

Is there anything quirky about the spreadsheet?

Sort of -- I designed it so that you can enter retirement ages of less than 65 and up to age 70, and so that you will run out of money at age 100 (you receive the investment return at the beginning of your 100th year). Also, some cells are not used in all of the calculations so that I could offer options for retirement age.

Defining what you want out of life and, more specifically, your money is covered in The Quiet Millionaire: Part 1 - What is Important about Money to You? and an honest look at your spending habits is discussed in The Quiet Millionaire: Part 2 - Major Obstacles to Financial Success. Mr. Wilder gives an even deeper discussion about retirement planning in Chapter 14 of his book The Quiet Millionaire, which I will cover in an upcoming post. (Note that I have received a copy of The Quiet Millionaire so that I could review the book for Wise Bread readers).

You may or may not be able to save all of the money you need to fund your retirement this year but getting started with any money at all will allow you to begin accumulating wealth; the Funding for Retirement spreadsheet can help chart your path and measure your progress.

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: