The investor needs to understand how a small difference in interest rate on long term savings makes a big difference to investment fund final performance.
Savers should closely monitor the performance of their savings as a small change in interest rate or investment return can have a major effect over the long term. So for pension investment the smart investor will seek to maximise interest rate as long as she can do so without incurring excessive penalties to switch between savings accounts or funds.
High Interest Savings Accounts
If a savings account is paying 5% per annum on a one-off investment of £10,000 then at 10 years it will be worth over £16,000 and after 30 years a little over £43,000. However the same £10,000 at 5.5% will have become £17,000 and nearly £50,000 at 10 and 30 years respectively.
The 0.5% difference in interest rate over 30 years causes the final value of the savings fund.to be worth 13% less than it could have been. A 1% difference in savings interest makes a 25% difference over the same 30 year period. The fund at 5% is worth £43,000 and the 6% account is nearly £57,500.
So it is important for the long term saver to avoid being stuck with below market savings interest rates. However the smart investor should also be wary of savings accounts which promise unusually high yields. If the rate is well above the rest of the market or central bank interest rate then it is likely not to be sustainable.
With accounts paying or offering unusually high yields there may also be a risk of losing all or most of the capital invested – depending on the amount and whether the account falls under a banking guarantee scheme. Even where it is guaranteed the monies may become inaccessible whilst the schemes assess the nature and scale of any bank default. Warning should be taken from the failure of Icelandic and other banks in 2007 and 2008. They were paying unusually high interest rates and then collapsed with the Credit Crunch.
Credit Card Debt
If a credit card has an interest rate of 17.5% then paying of a debt of £10,000 over six years will incur interest of just over £6,200. In other words, more than a third of the money paid out has gone to pay interest. To clear that £10,000 debt in six years requires a payment of £225 each month.
If on the other hand the interest rate is 15%, then the interest paid is a £1,000 less over the same six year period. If however the payments are kept the same, at around £225, the debt will cleared 6 months earlier and a further £500 of interest will be saved.
Shopping around for the best credit card or loan account is therefore well worthwhile as long as any transfer charges or penalties are modest. Arguably there should be none unless the customer is swapping very frequently.
Monitoring Interest Rates is Essential for Both Savers and Borrowers.
Being smart with their money is important for all who those people with savings or borrowings to manage. They need to understand interest rates and the impact even small changes in rate can have on their debts and savings. It is customers responsibility to ensure they are getting the best interest rate.
Everyone should take responsibility for the management of their money. No one should rely on, or even expect, their bank or fund manager to optimise the interest rates for the customer. They have other targets set by their employers.
First appeared on Suite101