For many, having a large amount of cash at hand seems like a perfectly adequate way to organize a financial safety net. There’s something to be said for the convenience of it, and some of your cash should actually be available, but there are also important downsides to this approach.
In this article, we’ll discuss the hidden costs involved in keeping cash on hand, as well as some alternatives that may utilize the savings more efficiently and profitably.
Inflation
The biggest problem with keeping cash on hand is inflation, which will erode some of its value. Inflation refers to an increase in prices or a decrease in the value of money. If a person holds on to their funds in cash, their real value in terms of purchasing power will decrease over time due to inflation.
Savings accounts provided by banks come with interest that the account holder earns simply by having the funds in a savings account. It’s the profit made from effectively borrowing money from the bank. The main purpose of such a profit is to cancel out the effects of inflation.
Opportunity Cost
Opportunity cost refers to the value of an alternative financial decision an investor could have made. For instance, if a person keeps $1,000 in cash, it produces no profits. Investing the same amount in an index fund yields a six percent annual return. The cost is therefore a profit from a potential investment.
The longer a person sits on the money they have, the more they deprive themselves of long-term wealth creation. It’s a matter of balance between the two, since savings are often just as important as long-term plans. Savings that don’t involve cash are, almost always, a better option.
Tax policy
There are also tax advantages made to help with saving and investing. These are usually provided by designating certain investment accounts as tax-free or tax-deferred. It means that the profits made from those accounts are not taxed or that they are taxed only when the funds are withdrawn.
None of these tax policies apply to saving money in cash, as it doesn’t provide any profit and doesn’t contribute to the broader economy. An investor should consider these tax advantages when deciding between saving and investing.
Erosion of Net Worth to Others
Keeping funds in cash rather than using other methods we mentioned also has an effect on others. It’s a subtle downside that often gets overlooked, but it has an impact that should be considered. The funds put into the investment account provide interest to those who have invested, but it also provides capital for the companies you’re investing in.
Investing, therefore, grows the economy as a whole, since businesses funded in this way would also pay employees, borrow, and engage in trade. Funds held as cash aren’t participating in the economy in any way and therefore don’t have this wider effect.
Alternatives to Keeping Cash
There are many more lucrative alternatives to keeping cash. We’ll address a few of the most common ones.
High-Yield Savings Accounts
These savings accounts function like any other savings account, but they offer a significantly higher interest rate. Sometimes, the interest rates are four to five times higher. The funds put into such accounts remain liquid, meaning you can withdraw them with a fee, and they are FDIC-insured. These accounts are ideal for use as emergency funds, as they can serve this purpose while generating profits.
Crypto Mining
Crypto mining used to require a lot of expensive equipment and technical knowledge. In recent years, as almost everyone knows how to build a mining rig, the barrier to entry has become somewhat lower. Crypto coins made by these mining efforts can then be bought and sold on the market. Unlike a savings fund, this method offers a faster and higher return, but with greater risk.
Certificates of Deposit
Certificates of deposit are a low-risk savings option provided by banks and credit unions. They provide guaranteed returns over a fixed term, usually ranging from 3 months to five years. In exchange for keeping the funds in the account for a set term, the investor gets a fixed interest rate. The downside of this approach is that it’s not as easy to withdraw the funds if you need them before the set term – there’s a fine for doing so.
Index Funds and ETFs
Index funds and exchange-traded funds (ETFs) are baskets of stocks or bonds that mirror the market index of their companies. The funds are diversified and therefore come with significantly less risk than selecting individual companies to invest in on your own. It’s an option for long-term growth.
Keeping cash on hand is somewhat convenient for smaller amounts, but it comes with several downsides, mostly because there are more profitable ways to use your savings. The value of savings kept in cash also drops due to inflation.
Comments