You can’t go wrong with keeping your cash with a bank, right? Keep your money in the bank and you know its safe, you may even earn some interest, but will your money be worth as much this time next year? Just because you are earning interest it doesn’t mean your money will be worth the same relative to the cost of living.
Real Interest Rates
The interest you earn on your money is only one part of the equation. To get the true rate of interest you are receiving (or “real” interest rate) we must also consider inflation. Inflation is defined as a sustained increase in the general price level of goods and services in an economy over a period of time. Simply put, it’s the rate at which the price of the things we spend our money on increases.
Let’s say you go to the supermarket and spend £200 on food shopping (maybe it’s Christmas). If the rate of inflation over the course of the next year is 3% then that same £200 food shop is going to cost you £206 a year later. However, if you have only been earning 1.5% interest on your money then £200 kept on the bank over the same period will only have increased to £203. Therefore, in this scenario you are £3 (or 1.5%) worse off. The difference between the nominal interest rate and the rate of inflation is the “real” interest rate.
Bank interest rate = 2.0%
Rate of inflation = 1.5%
Real interest rate = 0.5%
How do we ensure our money isn’t losing value?
To prevent our money from losing value we need to ensure the return we are getting on it is higher than the rate of inflation. At the time of writing, interest rates are very low and inflation is starting to rise. As a result many people will start experiencing negative real interest rates (if they aren’t already). This means that their money will be worth less in the future than it is now, relative to the costs of goods, as the cost of goods will have risen quicker than their savings. If you are unable to achieve a suitable interest rate from your bank then you need to be looking elsewhere for a good rate of return. If you want to build real wealth then you will need to do that anyway.
Let’s say you have £5,000 in savings and you are going to keep 60% of it in a low interest savings account and the rest in shares. Below is an example of the returns you would get over the course of a year and how that affects your real interest rate.
Money held in savings account: £3,000 @ 1.5% interest (£45 interest earned)
Money held in shares: £2,000 @ 4% dividend yield (£80 interest earned)
Rise in share price = 8% (£160 price increase)
Average return on £5,000 = 5.7% (£285)
Rate of inflation = 2%
Real interest rate = 3.7%
For those of you who have no investments other than the money held in a bank account I would recommend you do lots of research before you begin investing. If you have no previous investing experience then you should not be making stock purchases without professional help. However, you can begin to look at how you can increase the real interest rate you are receiving on your capital. This could be as simple as opening a new account with a different bank which has a better rate of interest. In time you will gain the knowledge and confidence to make your own stock investments (if that’s what you want to do) but don’t rush into it. Take your time and do it properly and you should make steady returns.
Keep a close eye on the rate of inflation and the amount of interest you are receiving and prevent your money from losing value!