Being smart with your cash

In today’s environment of low interest rates it is becoming increasingly difficult for savers to find a home for their cash which produces a meaningful rate of return. Accounts traditionally regarded as “risk free” are increasingly producing diminishing rates of return especially once inflation is factored in. Even when one has been lucky enough to identify an account offering higher rates than are typical, these often disappear before investors are able to take advantage of them, as banks limit their availability. Often the higher interest bearing accounts that are available require savers to tie their money up for a period of time after which the account defaults to a significantly lower rate. Banks rely upon the inertia of savers to move their account to take advantage of better offers once this fixed term has expired. This inertia can be due to a number of factors: either they have forgotten when the fixed period ends, they are too lazy or busy to look for another account paying a higher rate, or in some cases they have forgotten about the account.  According to recent research by Which?, savers are losing £4.3 billion a year by not moving their money from extremely low interest bearing accounts known as “zombie” accounts which used to pay good interest rates but now pay next to nothing. Apparently 8 out of 10 easy access savings accounts pay very low rates of interest and 4 out of 10 pay 0.1% or less.

Being smart with your cash takes effort. If you want your money to work for you then you have to be prepared to put the work in too. For savers with access to the internet there are many useful websites that can help in the search for the best rates available such as Moneyfacts.co.uk, GoCompare.com, MoneySupermarket.com, ThisIsMoney.Co.UK and CompareTheMarket.Com. For those who do not have access to the internet many Sunday Newspapers have a Money Section which lists the best rates available for savers, however this is not as comprehensive as the internet listings. Beware as some accounts provided by the same institution seem to have similar names but pay very different rates.

Four important considerations when choosing a home for savings are:

What is your tax rate?

How much are you planning to invest?

For how long do you plan to invest the money?

Do you intend to reinvest or withdraw the income?

Not all accounts are straightforward. Some require a monthly fee while others require savers to keep a minimum balance in the account. Additionally there could be rewards associated with some of the accounts which entitle savers to cashback provided certain criteria are met. This can mean that an account which levies a monthly charge could actually work out more beneficial provided the reward criteria are met! The websites allow comparison of the various accounts that are on offer and usually have a link to the providers’ own website from where more information can be found and allow online application.

If savers are not expecting to access their funds and would like to shelter the interest from tax, particularly useful for higher rate tax payers, then investing the money into a Cash ISA is a useful option. Interest rates tend to be a little higher on money that is tied up. Higher rate tax payers who have already utilised their ISA allowance could always put additional savings in the name of their partner if they are lower rate tax payers.

Savers need to take into account accessibility and ensure that the funds are not tied up for a fixed period if the money is likely to be needed within that time frame. Some accounts have a withdrawal limit so make sure that any potential calls on the savings fall within that amount.

It is important to ensure that the same type of interest rates are being compared. There are two versions that banks quote – the Annual Equivalent Rate (AER) which takes into account compounded interest over the year and the Gross rate which is the flat amount paid over the year. Both rates are usually quoted before tax. Some accounts will pay a bonus rate after a certain period.

There are other investments which are considered to be “safe” such as Premium Bonds and National Savings Income Bonds. There is no set term with Premium Bonds and sums between £100 and £30,000 can be invested. Instead of paying interest there is a prize draw every month with a £1 million jackpot and other cash prizes. All prizes are tax free and the funds can be withdrawn at any time with no notice and no penalty. The drawback however is that unless you are a winner in the draw your money is at the risk of erosion from inflation over time. Income Bonds allow investment from £500 to £1 million per person and again have no notice or penalty attached to them. The rates are variable and are currently set at 1.25% gross/1.26% AER. Further details of both accounts are available from the Post Office or online at nsandi.com.

One of the most powerful tools when investing is compounding. Re-investing the interest that is paid means that savings will grow quicker because you are not only earning interest on the original savings but also on the interest that is paid. For example: Assuming £100 per month is invested for 30 years at an annual interest rate of 3% this will produce interest amounting to £36 per year. At the end of the 30 years £1,080 will have been withdrawn and the amount saved will amount to £36,000.

However, if the interest is not withdrawn, then the amount that interest is paid on, rises each year. So instead of £36 interest being paid out in year one, this amount is added to the balance increasing it to £1,236. In year two, 3% interest is paid on this amount totalling £37.08, which is added to the balance, and in year three 3%  is paid on £1,273.08 and so on, until after thirty years of saving the balance reaches £58,273.68. This is 61.87% more than if you had taken the interest each year. Compounding can give a huge boost to savings from a small base.

Always remember not to invest more than £85,000 per person in any one financial institution as this is the limit for compensation under the FSCS should the bank collapse.

Darren Winters