How low interest rates can impact your savings

How low interest rates can affect your finances
How low interest rates can impact your savings
Reading time: 6 mins

When you’re actively saving with a bank, you’re typically guaranteed to get back what you’ve initially put in, plus a bit of interest – think of it as a little top up to boost your savings. Your profit will depend on the interest rate you’re getting from the bank, and if this rate is too low, your money may not be growing as much as it could. Here’s how low interest rates can impact your savings.

 

What are interest rates?
If you’re saving money in a cash savings account, the interest rate is the reward you get. Typically, you’ll be offered a fixed annual rate of interest from when your account is opened, such as 1%. This means that your savings will grow by 1% over the course of a year. So, if you save £100, you’ll have £101 in your account after 12 months. This provides some certainty for savers who want to see their money flourish. Not all interest rates are fixed though, and some will fluctuate over time, meaning your money could grow at a different pace one year to the next – these are known as floating or variable rates and they come with a bit more risk.

To set their interest rates, banks will consider the base rate, also known as the Bank Rate. Put simply, it’s the interest rate offered by the Bank of England (the ‘mother’ of all the banks in the UK, if you want) to other financial institutions, and it influences all other interest rates. For instance, when the base rate is cut from 0.5% to 0.25%, it means high street banks can borrow money from the Bank of England at a lower rate and reduce their own interest rates.

 

So, what’s the issue with low interest rates?
Low interest rates mean that your savings will be growing at a slower pace and it could take more time before you manage to reach your financial goals. For instance, if you earn 1% a year on your savings, you can’t expect to become rich overnight – unless, of course, you happen to win the lottery. But to fully understand the issue with low interest rates, you need to take into account the impact of inflation on your money.

Over the years, things get more expensive due to inflation, and if your income doesn’t follow the general rise of prices, your purchasing power, or financial ability to buy goods and services, will effectively decrease.

Inflation can also affect your savings. How, you ask? Well, if the rate of inflation is higher than the interest rate you’re getting from the bank, then your savings will be losing value in real terms. In other words, if you were to take your money out after a number of years, you’d quickly realise that you can’t afford to buy as much as you once could. The thing with low interest rates is that your savings are likely to grow slower than everything else.

The current environment isn’t favourable for savers. In March 2020, faced with Covid-19 and a slowdown of the economy, the Bank of England decided to cut its base rate at 0.1% to try and encourage people to borrow, consume, and invest1 - this is part of the country’s monetary policy to stimulate the economy and limit the impact of the crisis. So, as things currently stand, there’s not much incentive to save, unless you want to build or boost your short-term emergency fund. However, if you’re looking for potentially inflation-beating returns and real growth over the long-term, it could be worth considering other options, like investing.

 

Why consider investing?
Unlike saving, where your profit is tied to an interest rate, investing could provide you with higher returns. Of course, since your returns depend on how well your investments are doing, there’s also a risk that you may end up with less than you initially put in. But over the long-term, evidence suggests that stocks tend to beat cash.

A Barclays Equity Gilt Study found that stocks kept for any 10-year period since 1899, have had a 91% chance of outperforming cash2. But it doesn’t stop there! If you look at the annualised returns of the FTSE 100, the UK’s stock market where the 100 largest companies are listed, you’ll likely see returns that far exceed the rate of inflation. Since 1983, the FTSE 100 has returned about 7.08% a year (with re-invested dividends)3. Now compare this with the average inflation rate (RPI) in the UK between 1983 and 2019 which is set at 3.60%, and you’ll see that you would have beaten inflation most years4.

Investing can be a great way to make your money work harder over the long-term, but if you’re looking to give your money more potential, then it could be a good idea to invest in a tax-friendly way, like using a Stocks and Shares ISA. Not only will you be removing tax from the equation, you’ll also get to keep more of your returns.

If you want to open a Stocks and Shares ISA, why not use a digital investment platform, like Wealthify, where the hard work is done for you? All you need to do is choose how much you want to invest and the risk level that suits your needs. We’ll do the rest, from picking your investments based on your investment style to managing your ISA on an ongoing basis to ensure you benefit from any opportunities that arise.

 

References:

1: https://www.moneysavingexpert.com/news/2020/03/base-rate-cut-to-0-1-/

2: https://moneyweek.com/505257/stocks-beat-cash-and-bonds-over-the-long-term

3: Data from Bloomberg

4: https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/czbh/mm23

The tax treatment depends on your individual circumstances and maybe subject to change in the future.

 

Please remember the value of your investments can go down as well as up, and you could get back less than invested.

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