Savings are essential for your financial security, and cash is a low-risk way to save. The problem is that between low interest rates and inflation, you might end up with less buying power than you started off with. Let’s take a look at why.[top_pitch]
What is inflation?
Inflation is the rise in prices over time. There are many reasons for inflation, and a little bit of inflation is a sign of a healthy economy. The problem is that, over time, cash loses its buying power. If inflation is 2%, then a basket of food that cost £100 last year will cost £102 this year. In 10 years, it’ll cost about £122.
What does inflation have to do with interest rates?
Think about that £100. If instead of spending it, you put that £100 under your bed, it will actually be worth less in 10 years than it is today. But as responsible, financially literate people, we don’t keep our money under the bed – we put it in savings accounts and earn interest. The thing is, just for your money to hold its value, the interest rate needs to equal the inflation rate.
If both the interest rate and the inflation rate are 2%, then in ten years your £100 will be about £122. You’ll still be able to buy the same basket of food – you won’t have lost anything, but you won’t have gained anything either. But if the interest rate is lower than the inflation rate, your money will still lose its buying power.
What’s happening now with inflation and interest rates?
Jack Turner, senior investment manager at 7IM, explains, “As the world begins to reopen and investment and consumer spending rebounds we’re likely to see an uptick in inflation in the future. If you hold too much of your financial reserves in cash, you only allow inflation to eat away at its spending power. Extremely low interest and faster than expected rises in inflation put these savings in even more danger of losing value.”
If the interest rate on your savings is 1.5% – which is quite a good interest rate right now – then with 2% inflation, you’re losing 0.5%. If like many people, your interest rate is only 0.5% or 0.6%, then you’re losing up to 1.5% a year![middle_pitch]
So what else can you do with your money?
Jack Turner suggests that “Investors should look to fully diversified multi-asset portfolios as an option for protecting the purchasing power of savings in the long term. Bonds no longer provide the same protection as they once did, but using a mix of inflation-beating alternatives and equities in a portfolio can give savers the security they need.”
As the world reopens, inflation is likely to rise – that’s a sign of a healthy economy. If you invest in the recovery rather than relying on low interest rates on savings, you could benefit from positive returns.
Of course, with any investment past performance is not an indication of future results, so invest carefully. However, don’t weigh the investment risk against the risk of any loss at all, weigh it against the loss you’ll suffer as a result of inflation.
The post Why low interest rates puts savings in cash at risk appeared first on The Motley Fool UK.
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