To Put It Bluntly: Why Your Saving Account’s APY Is a Lie


Everybody with a savings account is complaining about low interest rates. And they have a point: money market funds are still yielding close to zero, and the best online savings accounts are offering about 1%. Back in 2008, I remember getting 5% on my online savings account, and I felt like I was living large.

Here’s the problem, though: that APY is a lie. In fact, every APY reported on every savings account and CD is a lie. Worse yet, it’s impossible to figure out how big a lie it is until (cue dramatic music) it’s too late.

The APY is a lie because it only tells you how many dollars you’ll receive in interest. It doesn’t—and can’t—take inflation into account. Only Scrooge McDuck cares about dollars; the rest of us care about stuff. “If you put your money away for a year, how much stuff can you buy a year from now with the accumulated savings that you have?” says Greg Ip, a writer for the Economist and author of The Little Book of Economics.

The interest rate listed in bank ads and email alerts is called the nominal rate. If you subtract out the rate of inflation, you get the real interest rate. Currently, according to the Bureau of Labor Statistics, the inflation rate in October was 1.2%. That means stuff cost, on average, 1.2% more in October 2010 than October 2009.

So, let’s see. If we round my 1.19% interest rate to 1.2% and subtract out the inflation rate, we get a big fat zero. Life was so much richer in mid-2007, when I was earning 5.5%, then?

“In 2007, you were pulling in 5.5%,” says Greg McBride, a senior analyst at Bankrate. “The problem was, oil was at $147 a barrel, and inflation was running 5.5%.”

Yep, in real terms, that’s zero again. Hmm.

Defibrillating the economy

So am I saying that real interest rates never change? Not exactly. McBride and Ip agreed that, even measured in real terms, the current rate is still low. “The conventional wisdom that savers are kind of getting the short end of the stick here is basically true,” says Ip.

That’s a matter of policy. The Federal Reserve is trying to shock the economy back onto a regular heartbeat (sorry, House was on last night). “Making savers realize they’re getting a lousy deal is—not to put a fine point on it—kind of the whole idea here,” says Ip. If everyone is trying to save or pay down debt at the same time, the economy can’t grow. Maybe I’ll look at the low rate on my savings account and decide this would be a good time to take a low-interest loan to put an addition on my house or start a new business. Or I might look for higher returns by buying stock, giving a company an infusion of cash to spend.

These are the outcomes that would make Ben Bernanke happy. But just because he’s sending an invitation doesn’t mean you have to go to his party. If you have your money in a typical bank savings account, yes, you’re losing purchasing power every day. “Now, if you have your money in one of the top-yielding savings accounts and CDs, then your real return, as measured by the CPI, is still slightly positive,” says McBride.

The point is: looking only at the nominal rate on your account can lead you to take on more risk than you might otherwise feel comfortable with—or it can lead you to annoy your friends by complaining about your interest rate.

Oh, there’s one other wrinkle. So far we’ve only been looking at past inflation, which can tell you how your savings have grown (or not) in the past. Nobody knows for sure whether we’ll have inflation, deflation, or price stability in the future. But we can make a guess by looking at bond prices or by checking the Philadelphia Federal Reserve’s quarterly survey of professional forecasters. Right now they’re predicting 2% annual inflation over the next five years.

Saving up for some fun

One final point. Saving is most fun and easiest to do when we’re saving for something in particular. And the thing we’re saving for can have a powerful effect on our real interest rate.

Why? Because inflation isn’t just one monolithic number that affects everything equally. Food prices can go up while housing prices go down. “Everybody has to compare their interest rate against their own circumstances,” says Ip. “If you’re a person who’s spending a lot of money on college tuition and medical insurance, then you’re feeling really squeezed, because those things are still going up in cost.” But if you’re saving for a house down payment or a computer, rest easy: prices are static.

That could change anytime: college tuition could stagnate and a new housing bubble could inflate anytime. If you think about this too hard, you realize that the $1,000 in your savings account is also kind of a meaningless number: I know what it buys today and probably what it’ll buy next year. In five years, who knows? The Federal Reserve exists, in large part, to minimize that sinking feeling.

I live in earthquake country, and every time we have a small tremor, I have the same kind of feeling as when I think about inflation: everything seemed so solid, and then, lurch.