Remember the first time you received interest from your savings account? Whether it’s $100 or just 10 cents, it’s a magical feeling seeing “free” money appear in your account. But feelings can be deceptive, and if you think you’re earning significant money from a high interest savings account, you should look closer.

Savings accounts: what are they good for?

Savings accounts are a good solution for those with shorter-term financial goals where you can’t take any risks with your money. After all, you never see your savings account going down, like you might with an investment.

But if you’re trying to grow your money, a savings account is not the best place to keep it. As Warren Buffet said:

“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.”

Current interest rates

Let’s get technical for a moment. The interest rates from a high interest savings account reflect the official cash rate set by the Reserve Bank of Australia, which is currently a modest 1.50% p.a.. Currently, most high interest savings accounts shows standard variable rates ranging from 1.20% to 1.75% p.a., and bonus interest rates are in the 2.95% to 3.15% p.a. range.

The bonus rates do come with strings attached. Often the higher bonus rate applies only for a limited honeymoon period on balances up to a certain amount. Sometimes you have to add minimum monthly additional contributions to get the bonus rates. Whatever it is, to access the bonus there are usually some conditions.

As with most financial products, the devil is in the details, read the terms and conditions of any bonus rate carefully.

What you see isn’t what you keep

At first glance, it might appear that high interest savings accounts are an easy way to make “free” money. But is this really true? When you account for inflation and tax, you’ll see that the rate of return is much smaller than you’d think.

In investing it’s not what you earn but what you keep that matters. And to calculate that, you need to subtract the costs, taxes and inflation. At Clover we call this the “hip pocket return”, and it’s the only return that matters to savvy investors.

Putting your money to work

What if you put $10,000 into a high interest savings account five years ago? What would it be worth today?

To look at the real worth of our savings account, we need to adjust the account balance as we see it in our account for two key items — inflation and taxes. Inflation erodes the purchasing power of money — basically, a dollar today is not the same as a dollar two years ago in terms of its real worth. The purchasing power of a dollar today is lower than what it was two years ago due to a general increase in prices of most goods and services ranging from a loaf of bread to a haircut.

Any interest we earn on our savings account is treated as income and is taxable in the year it was paid. So without adjusting our savings account balance for inflation and the tax on interest earned, we don’t know the real worth of our account.

In order to estimate the real worth of $10,000 invested in a high interest savings account five years ago, we can use the historical interest rates on retail savings accounts/bonus accounts and adjust the data for inflation and tax impacts.

As the chart below shows, $10,000 invested during 2011 in a high interest savings account would have grown to $12,014 over the five year period. After adjusting for the effects of inflation and tax however, that $10,000 would have been worth only $10,438, a return of 0.86% p.a. over the five year period. 😳