What’s the best place for your savings? Cash under the bed? In your current account? In a cash ISA? Actually, all of those things will lose you money. In this episode we explain why that is and what you can do about it.
So, the trouble with just having money in the bank is inflation. Let’s say you go out this week and you spend £100 on groceries. Over the last 5 years, the Retail Price Index for inflation has been about 2.5% per year, so if you go next year and buy the exact same set of items, it will cost you on average about £102.50. So that means if you kept £100 in the bank for a year without earning any interest, it’s effectively worth less than it was to start with. It might be the same £100, but you now have less spending power so you’re worse off than you were.
So what about cash ISAs or accounts that earn interest? Well the best cash ISAs right now could earn you about 0.5% interest. Now we need to do some maths to adjust for inflation and work out what the real return is, but don’t worry, it’s really simple. So you take the 0.5% interest you earn from an ISA, and adjust for inflation by subtracting the 2.5% for inflation and you get -2%. So great, instead of losing 2.5% per year you’re losing 2%, but you’re still losing money. This is why a cash ISA should not be thought of as an investment — it’s actually making you worse off!
So what can you do about it? Well, we need to look at other places to put our money that will get an inflation beating rate of return. We need to look into things like stocks and shares and real estate that get an average of around a 7 or 8% return each year. Now of course the stock market and property are not at all guaranteed, and investments need to be for the long term (5 years minimum). Stock prices go up and down, but given enough time history shows us that the stock market as a whole has beaten inflation. If we adjust for inflation again, so subtract 2.5%, we’re still at around 5%, so now we’re actually making money!
I know investing is a very daunting prospect for many, but it is something that we all need to be doing in some way if we want to grow our finances instead of losing out to inflation. We’ll have more episodes in the future that cover how you can get started with investing.
Another thing you can do to effectively beat inflation is to pay off debt, such as your mortgage. By paying down debt you are increasing your net worth, which is the same end goal as investing. If your mortgage is at say 3.5% interest, you can think of paying that down as an investment that gives you a 3.5% return. Unlike the stock market which is unpredictable, this is a guaranteed return, and when interest rates rise in the future it will prove to be even more worthwhile. So again, 3.5%, minus the 2.5% for inflation, and you have a 1% per year real return that is guaranteed. In my opinion, that’s not a bad option.
Of course cash ISAs do have their place. We recommend having three to six months of living expenses saved in an emergency fund (which you should have in place before you think about investing), and an unrestricted cash ISA is probably the best place for this. Investing is for the long term, but an emergency fund needs to be available when you need it so having it tied up in investments is not a good idea. You might be losing out to inflation with the money in your ISA, but at least the small amount of interest is helping to mitigate this.
But let’s be clear — a cash ISA is not an investment and it will lose you money over time thanks to inflation.
I hope that’s been useful. Just to be clear, I’m not a financial advisor and this should not be considered as financial advice, I’m just sharing what I’ve learnt. Remember, your investments can rise and fall in value – that’s why the money you invest should not be money you need in the next five years and the investment should be held for the long term. If you are going to invest money, make sure you take advice before hand. You’re better having a guide in this area as too many people have lost money through not understanding investing. If you have any questions or suggestions for what we should talk about next, you can leave a comment on YouTube or email firstname.lastname@example.org.