Since the beginning of 2020 when COVID-19 hit, interest rates in Australia and around the world have fallen to record lows.
We explain what this means for your ‘high interest’ savings account.
Why are interest rates so low?
Well before COVID-19, interest rates were falling in Australia and around the world due to lower consumption, weak wages growth, low inflation, and high household debt. Economies were slowing down and people were spending less.
In light of these circumstances, the Reserve Bank has gradually been lowering interest rates, which has encouraged spending, lending, investing and borrowing.
This is all good news…but the bad news is the effect low interest rates have on your savings account.
How long will interest rates stay low for?
Whether interest rates go up or down depends on inflation and the unemployment rate. Many economists say unemployment it will stay around the 6-7 per cent mark for 2021 before slowly going down after that. Forecasts like this make it likely that the Reserve Bank won’t raise interest rates for several years.
For higher interest rates to occur, we’d need strong and improving employment as well as inflation, but it will take a while for us to recover from the blow we suffered in 2020.
What do low interest rates mean for my savings account?
To answer that, we should first think about why you need your savings to grow in the first place. Isn’t it enough that you’ve put some money away?
Unfortunately, no. Let’s start with a simple example. If you put $100 in the bank, you can be be assured it’s safe and you’ll still have $100 if you decide to withdraw it in 10 years.
The problem is, in 10 years, things will cost much more (see The Reserve Bank’s Inflation Calculator to test this theory), and your $100 won’t be able to buy you as much.
That’s why high interest savings accounts were seen as an effective way to protect the value of your money. If you left that $100 in a high interest savings account and didn’t touch it, it would appreciate a little bit more each year.
This was a great strategy when interest rates were higher. These days, that same high interest account might give you a return of between 1% and 2% per year (if you’re lucky). And that’s before tax, which could cut that return in half again if you’re in a high tax bracket.
Essentially, low interest rates mean that Australians simply stashing cash in a high interest savings account are likely to see the value of their hard-earned money fall in comparison to the rising cost of goods and services.
What are the alternatives to a high interest savings account?
Over 30 years, interest rates have gone up and down, but returns on cash alone have lagged behind bonds and shares by about 2% to 4% per year on average.
That might not sound like a lot, but $10,000 left in a savings account 30 years ago would be worth about $75,000 today compared to over $129,000 in Australian shares.
If you want to grow your money in a real way, you’ll need to take some risk – and that means investing in assets like shares and bonds.
Yes, investing can be risky because the share market is volatile. Yet even with the market highs and lows over the past 30 years, the share market has still returned an average 8.9% per year in Australia and 10.3% per year in the US.
Compare cash which returned an average of 5% per year over the same period (yes, the return on cash was once that high).
What if share prices fall?
One guarantee when you invest is that your account will go down in value from time to time. Sometimes the value will fall a lot and go into a ‘bear market’. A bear market is when shares fall at least 20% from their high. There have been 12 bear markets since 1950.
Over time shares recover from bear markets and go higher. The 8.9% return that Australian shares have made over the last 30 years includes several bear markets including 1987, 1994, 2002, 2008, 2015 and most recently 2020.
Invest in shares for the long-term
A 8.9% return over 30 years will turn $10,000 into $129,000. If you can top that account up with another $250 per fortnight over that period you’d end up with $1,000,000. This is due to a wonderful thing called compound returns.
What is the best strategy?
As you can see, investing can be a risky option. Money in the bank will either stay static or grow by tiny increments with interest. Investments, on the other hand, go up or down on a day-to-day basis.
The way to mitigate your risk is to understand the tenets of good investing, and to diversify your portfolio. Diversification (i.e. having a mixture of investments that complement one another) will reduce your risk significantly compared to stock picking at random.
Exchange traded funds (ETFs), like those offered by Stockspot, are a good option for the risk averse investor. A single ETF provides exposure to hundreds of companies, but a fully diversified Stockspot portfolio has share ETFs, gold ETFs and bond ETFs.
When you have a fully diversified Stockspot portfolio, you get exposure to hundreds of different companies, but you’re also investing in other asset classes. You’re diversifying your investments across high growth/risky assets like shares, but also more conservative assets like bonds and gold.
How much should I keep in a savings account?
With the savings interest rate so low, it might be tempting to take all of your cash out of your online savings account and transfer it over to an online investment account.
But a stash of cash is always needed and you don’t want to keep taking money in and out of your investments because this will affect long-term growth and you don’t want to be withdrawing when markets are down.
As a rule-of-thumb, you should have 6 months worth of living expenses available in the bank in case of emergencies, medical expenses, home repairs, car repairs, fines, fees, etc.
Once you have that sorted, consider investing the rest of your extra cash in a diversified manner. If you have time on your side, your money will be able to work for you and provide you with returns over the long term.