Whether you’ve been working on your finances for years or you’re just getting started, it can be difficult to know when you should be saving and when you should be investing.
Saving is the safer route because the dollar amount in your bank account won’t typically decrease unless you withdraw funds, but interest rates on savings accounts don’t allow your money to grow very quickly. Unfortunately, interest rates are often lower than the rate of inflation. This means your savings could lose purchasing power over time.
It’s tempting to want to invest to receive higher returns and beat inflation. Unfortunately, the value of your investments won’t always go up. In some cases, investments can become completely worthless.
So, how do you know when you should stick to the safer route and save or risk more to earn bigger returns and invest? Here’s what you need to know.
Pros and cons of saving vs. investing
To give you a general sense of the pros and cons of both investing and saving, here’s a table.
Pros of saving
There are plenty of benefits to saving rather than investing. First, the dollar amount you save in a savings account won’t decrease over time as long as you don’t make withdrawals. This is important because some goals need to happen regardless of whether investment prices are up or down.
Saving rather than investing also allows you to reach your goal on time as long as you save the proper amount each month. Take the total you need to save and divide it by the number of months until you need to reach your goal to find the amount you need to save each month.
Cons of savings
Saving does have downsides though. Due to inflation, the money you save will decrease in value each year. If you earn interest, that interest may partially offset the negative effect of inflation. Unfortunately, interest rates rarely keep up with the rate of inflation.
Saving also means you’ll have to set aside more money each month than you would if you received higher returns investing. If you’re only earning one percent interest in a savings account but could earn an eight percent return investing, you’ll have to make up for that seven percent difference by putting more money in your savings account to reach your goal at the same time.
Pros of investing
Investing can be beneficial, too. Investing gives your money the potential to grow faster than it could in a savings account.
If you have a long time until you need to meet your goal, your returns will compound. Basically, this means in addition to a higher rate of return on investments, your investment earnings will also earn money over time.
The benefit of higher compounding returns is you won’t have to invest as much each month as you would need to save each month to reach your goal.
Cons of investing
Investing isn’t always a good thing, though. Investment prices could go down right before you need the money which could leave you in a financial bind.
If this happens, you will have to either settle for an option that doesn’t cost as much, delay your goal until you can save more money or delay your goal until your investments increase in value.
A savings account is a bank account that allows you to set money aside and earn interest in the process. Some savings accounts pay a lower interest rate while other savings accounts offer higher interest rates that can actually help you grow your money.
Money Market accounts
A money market account is like a savings account in the fact that it earns interest. However, this type of account may also allow you to write checks, too. Unfortunately, money market accounts sometimes have higher minimum balance requirements.
Banks may also be able to restrict the number of withdrawals you can make on these accounts before you have to pay fees, too. Money market accounts usually offer higher interest rates than savings accounts, but that isn’t always true. Discover and CIT Bank both offer money market accounts you may want to consider.
Savings bonds are issued by the government. Essentially, you buy a savings bond and earn interest over time. However, interest rates on savings bonds aren’t always great. In fact, you could earn more money by putting your money in an online savings account in some cases.
Savings bonds typically work out best if you hold them to full maturity, which can take 20 years. If you redeem them early, you may have to pay an interest penalty.
Certificates of Deposit
Certificates of deposit (CDs) allow you to earn a higher interest rate on your money. Typically, you promise a bank that you won’t withdraw the money for the term of the CD in exchange for earning a higher interest rate on your money.
You may be able to withdraw the money early depending on the terms of your CD. Usually, you’ll have to pay an interest penalty. Some CDs offer penalty free withdrawals, but they typically offer lower interest rates.
Rather than dealing with a person, software will build a portfolio for you based on your risk tolerance, goals and other factors. Because you aren’t dealing with a traditional advisor, the fees for these services are typically lower. However, they still cost more than doing it yourself.
Each app has its own selling points. For instance, Stash Invest aims to making investing easier by allowing you to start investing with just $5, but they charge a 0.25 percent fee for accounts with $5,000 or more. They group investments into themes to make investing a bit easier to understand, although this may not be the best way to invest.
Traditional brokerage accounts, such as those offered by Ally Invest and Fidelity, are essentially accounts you can use to purchase investments. They typically offer the greatest flexibility when it comes to investing. Each brokerage will have their own features and fee schedules, so be sure to shop around to find the best brokerage account for your situation.
When to save and when to invest
Knowing when to save or invest can be difficult. Every person’s situation is truly unique. You should base your decision on your particular situation.
If you’re not sure what to do, you should consult a fiduciary financial advisor that can help you decide. However, there is a general framework that ends up working for many people:
Step 1: Build your retirement account
First, get your 401(k)’s or other workplace retirement account’s matching contribution. If your workplace matches the money you put into your retirement account, it’s essentially free money you shouldn’t pass up.
Step 2: Build your emergency fund
Next, build a small $500 to $1,500 emergency fund in a savings account. A small emergency fund is essential to help you stay out of debt for good.
Rather than putting small emergencies on your credit card that could dig you deeper into debt, you can rely on your emergency fund to cover small emergencies.
Step 3: Pay off debt
After you build your small emergency fund, pay off high interest rate debt. What you define as high interest rate is up to you, but definitely includes debt with interest rates 10 percent and higher.
Step 4: Max out retirement accounts
Next, invest and max out an IRA. It’s up to you whether you choose an IRA or a Roth IRA, but either way you should invest in a tax advantaged account. In 2018, you can contribute up to $5,500 per year and, if you’re 50 or older, an additional $1,000 per year catch-up contribution.
After that, max out your workplace retirement account. The reason you do this after an IRA is because you have more options for where to invest your IRA. You can choose where you hold your IRA and what it invests in while a workplace retirement account is limited to the options your specific plan offers.
You’ll need to factor in one time goals, too
You’ll also need to save for major one time goals, such as buying a home or buying a car with cash. It’s up to you where you fit these goals within the structure listed above. You’ll balance these goals with your retirement investing to make sure you reach both goals within the timelines you’re comfortable with.
You’ll have to decide whether to save or invest to reach these goals depending on your flexibility and time frame of your goal. If you absolutely must reach a goal by a certain date, you’re probably better off saving rather than investing. If you’re a bit more flexible about when you reach a goal, investing may be an option to consider. You could receive higher returns on your money, but a bad year in the markets could substantially delay when you reach your goal.
How to decide whether to save or invest
Deciding whether to save or invest for a particular goal can be difficult. Here are two concepts that can help you decide which is better for you.
If you have short-term goals, save
First, if you absolutely need the money by a certain date, save rather than invest. With saving, there is no risk of your balance decreasing. On the other hand, investments can decrease in value.
If you have long-term goals, invest
Next, investing provides an opportunity to get greater returns if you have a long time horizon and can delay your goal if things don’t go as planned.
The key is being able to delay your goal. If investments are down at the time when you originally planned to reach your goal, delaying by a couple years could result in your investments returning back to a higher value.
Or, do both
Of course, you can mix saving and investing, too. You can save the money you absolutely need and invest the money that would be nice but isn’t necessary to meet your base goal.
Another option is investing toward the beginning of a long-term goal and slowly switching to saving as your goal gets closer. This helps avoid a sudden drop in your investment values that could delay your goal.
Ultimately, it’s up to you to decide whether saving or investing is the better choice to reach your financial goals. To help you decide, here’s a quick diagram to summarize some of the more important factors you should consider.