This is a guest column by Mike Holman, the blogger behind Money Smarts Blog.
I get distressed when I hear about people who want to invest in “something better” than high interest savings accounts, because interest rates are so low. For most of us who like to think of 5% or 6% as a decent interest rate, it can be disheartening to see posted rates of 2% or 1% or even less.
There are a couple of problems with this way of thinking which might get you into trouble. I’m going to cover the reason you shouldn’t care too much about the interest rates in your savings account, as well as why looking for higher rates can cause you grief.
Interest rates don’t matter
First of all, let’s consider the idea of “real return”. With respect to bank accounts, the real return on your money is the actual return (determined by the posted interest rates) minus the inflation rate.
The real return indicates how much extra purchasing power you have over time.
For example, let’s say you are earning 3% in your bank account and the inflation rate is also 3%. If you deposit $1,000 today, then in one year’s time you will have approximately $1,030 in the account. You may feel $30 richer, but inflation has increased the price of everything you might want to buy by 3% or $30 as well.
As a result, the purchasing power of your original $1,000 deposit has not changed over the year, even though you now have $1,030. Of course in reality, the official inflation rate probably won’t correspond exactly to all the items you spend money on, but we’ll assume that is the case for this article.
In our example, the inflation rate is equal to the bank account interest rate. If that is always true, then it doesn’t matter if the posted rate is 2% or 22%, your effective wealth increase will be zero.
This is also true if the inflation rate is different than the posted interest rate, but the spread is constant. For example if the posted interest rate is 3% and inflation is 1%, then the real interest rate is 2%. If the interest rate is 30% and inflation is 28% then the real interest rate is still 2%.
My impression is that most people are happier with the higher interest rate scenario because they feel like they are getting a better return on their money, when in actual fact – both the high and low interest rate scenarios are pretty similar.
The bottom line is that the increase or decrease of your purchasing power, which is expressed in terms of the real interest rate, is what you should be concerned about, not the posted interest rates.
You are better off with lower interest rates in a taxable account
Usually when someone talks about high interest savings accounts, they are referring to taxable accounts. In that case, any interest payments are taxable income which means that the higher the interest rate, the higher the tax.
In the first section of this article, we assumed that interest rates are similar to the rate of inflation. If you are paying income taxes on the interest payments, then there is a good chance that your posted interest rate minus tax is actually lower than the rate of inflation and you are losing purchasing power.
One of the problems with being in a high inflation/high interest rate environment is that the higher interest payments will result in more income taxes. If you earn 3% interest on $1,000 and you are in a 40% tax bracket, then you will owe taxes of $12.00. If interest rates are 20% then the taxes will be $80.
The person in the high inflation/high interest rate scenario loses more of their purchasing power due to taxes than the person in the low inflation/low interest rate scenario. The reason this occurs is because the loss in purchasing power is the difference between the posted interest rate (less taxes) and the inflation rate which is a percentage. This percentage translated into a dollar figure which is higher in the high interest rate scenario. This chart is from a spreadsheet I did which hopefully illustrates this point.
|Rate||Tax||Inflation||Deposit||Gross interest||Tax||Net interest||Real return||Change in purchasing power|
Just to be perfectly clear, I’m not saying you should shop around for the lowest interest rates to save on taxes. I’m just comparing someone who is in a low interest rate environment to someone who is in a high interest rate environment.
Don’t invest in higher risk investment products just to get a higher return
There is nothing wrong with shopping around for higher bank account or GIC rates, but don’t make the mistake of increasing the risk of the investments for the sake of a higher rate.
It is very tempting to look for higher paying, albeit riskier investments in a low interest rate environment. Buying dividend stocks, REITs, lower quality bonds (probably in a mutual fund), are examples of investment opportunities that pay a much higher rate than any savings account.
The problem is the risk level. Buying junk bonds is far riskier than having the money in the bank, so the return has to be higher to make up for the extra risk. There is nothing wrong with any of those high yield investments I mentioned, but the question you have to ask yourself is:
Is it my goal to invest in riskier investments to get a higher potential return on this money?
If the answer is “yes”, then why did you have the money in the bank account in the first place? Why didn’t you buy REITs or stocks or whatever to increase the potential return?
I think the answer is most likely to be “no”. You had the money in your bank account because you need it in the near future. Maybe to pay for groceries next week or maybe for a vacation at Christmas. In this case, your main goal is to not lose any of your money. Interest payments are a bonus. Riskier investments are more suitable for longer time horizons.
- Bank account and GIC interest rates are not meaningful without subtracting inflation. Just ignore the fact that interest rates are “low” or “high”.
- Determine what your goals and time line for your money is.
- Figure out an appropriate investment type in terms of risk, liquidity.
- Shop around within that investment type for the best rates.
About the Author: Mike Holman write about Canadian personal finance at Money Smarts Blog and also wrote The RESP Book: The complete guide to Registered Educational Savings Plans for Canadians available only at Amazon.
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