The wonder of compound interest

To ensure your cash performs in a post financial crisis market, it’s vital to get to grips with how bank interest rates now work relative to inflation. Pre-2008, consumers could simply apply for a savings account which promised a return of 5 per cent or more on their cash and easily outperform inflation.

Now we have an ultra low interest rate environment and banks benefit from extraordinary levels of liquidity provided by the Bank of England. It is more important than ever that consumers need to be more hands on with their money. The good news is that there are now many more banks competing for deposits and the rates consumers can achieve are beginning to improve

All the pieces are in place but inertia remains biggest obstacle.  An understanding of the valuable effects interest can have on a simple cash deposit could provide the motivation required to pursue better rates.

A recent new product from one challenger bank means you can now earn 1.20 per cent on easy access savings and 1.80 per cent on a 1 year deposit. Compare that to 0.05 per cent with the big five high street banks and it seems a no-brainer. 

Very simply, 1.80 per cent on £100,000 in savings would add £1,800 to your income every year. But compound interest can make this money go much further, with higher returns achieved on that initial £100,000 in year two as the first year’s interest also then starts earning interest. Across the two years, that’s a total of £3632. 

-Top 10 most popular investment trusts – November 2017

In ten years’ time, this initial £100,000 deposit plus any interest payments received will have earned a total of £19,530 just in interest. What’s more, this calculation assumes a constant rate of 1.80 per cent, but given the recent Bank of England hike, savers could see higher returns when banks pass on the rise, and if there are additional hikes in the coming years. 

While interest rates look low at face value, the compound interest effect is extremely important. Those who act on the concept can realise the full potential of their savings and mitigate against the damaging effects of inflation

Savers need to remember how damaging inflation can be and how this impacts potential returns on their cash. Keeping a low, positive and stable inflation rate is vital to a strong economy. However with inflation currently high compared with interest rates, it’s difficult to beat price rises.

Understandably, most people don’t have the time or patience to scour financial websites and seek out the best rates for their money. Moreover, when interest gets paid out into a current account, it’s much more appealing to spend it rather than reinvest it.

We feel that rate increases as well as the new banking regulations are making saving easier for consumers in many ways. Open Banking in particular, which comes into force in January 2018, will make banking more accessible. 

-NS&I launches ‘growth and income bonds’: should savers sign up?

By providing access to consumer banking transaction data to approved third parties, it will pave the way to easier and more streamlined saving mechanisms.  People need to be able to compare returns available on different accounts, so they can make the best choice to protect and grow their cash. Open Banking will facilitate new solutions to help spark a stronger culture of account switching. 

It will also ramp up opportunities to create products and services targeted at sections of the market whose financial needs are not currently being met.  It’s likely we’ll see a more specialist or niche banking market open up with more diversification as these third parties hone in on gaps in the market.

With the existence of new platforms which take away the vast majority of the work involved, savers do have the tools to take action.  Compound interest and fighting the negative effects of inflation are two ways that we can all benefit. 

A lack of understanding about the interest rate environment means there’s more than £1.5 trillion of inert cash in the UK. Improving returns on this by even 1 per cent would release £15 billion back to savers and ultimately the UK economy. A more active approach to cash management is required for savers to capitalise on the compound interest effect and get the best rates for their cash.

Giles Hutson is CEO of Insignis Cash Solution.

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