A real interest rate is an interest rate that has been adjusted to include the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. Inflation reduces your purchasing power over time.
So any cash hoarders who like to keep it under the mattress, be aware that this time next year, your cash will be worth less and will get you less.
Another example of poor personal finance
After some lucky breaks at work, I built up around £70,000 in Premium bonds. We are going to say that I had it in there for 3 years. My interest rate worked out at about 0.5%. If the inflation rate was 3% during this period, it means the money was losing value at a rate of 2.5% per year.
In real terms after 1 year it was worth £68,250.
After 2 years, it was worth £66,543.
At the end of 3 years, I am down to 64,880.
This was at a time when personal finance wasn’t a priority. I was still chasing the pot at the end of the rainbow with my Premium Bonds, Lottery tickets and football bets.
We can use property to emphasise the point. Let us say I am a landlord with 2 properties and I have them both on interest only mortgages.
I have put them on interest only because I want the security of the cash flow just in case and I also want the option of paying a big chunk off the mortgage in a couple of years time. In this scenario I don’t need the money and am going to put it into a savings account with an interest rate of 1%.
The cash flow pcm is £200 on each property and £400 in total. This gives me a total of £4800 per year.
This is a good amount to save but what I am missing in this instance is the effect of inflation. I am happy with my £4800 but if we use the inflation rate above (3%) my savings are going to lose value over time.
In just 1 year our money is now worth £4704 due to the real interest rate (1% – 3% makes a real interest rate of -2%). After 5 years this negative compound interest would reduce the value to £4338.
Personally I would pay this off the mortgages at the end of each year. That means you have some cash flow as a back up during the year but once you are confident you don’t need it, look to reduce the mortgage.
If you are in a situation like this don’t put the profits into a 1% savings account for years when you don’t need the cash flow on a monthly basis. You are also getting charged 3% interest on your interest only mortgage so that is another reason to reduce the mortgage down as opposed to leaving it in a 1% savings account.
Another option would be to invest in an Index fund through an ISA. I am convinced you can get 7-8% if you invest long-term. My Life strategy 80/20-index fund is 14.5% up after 12 months.
This will go up and down as markets go through periods of uncertainty and then rise on periods of promise and confidence. What I am trying to say is that you really need to be aware of interest rates and don’t settle for 1% or less.
If you are aware of interest rates you have a chance of understanding real inflation and how it can eat away at your hard earned savings.
Here is an example of how poor I have been at personal finance. During the period I had premium bonds, for 2 years in a row I took a loan out to pay my tax bill for my Limited Company.
So I am earning 0.5% from the Premium Bonds and then end up with a £20,000 loan with an interest rate of 6.8%. I didn’t have a clue about interest rates; I just had tunnel vision as I actually thought I had a chance of winning £1,000,000 from the Premium Bonds.
Please don’t make the same mistakes as I have made and get to a point were you fully understand interest rates and real interest rates. Governments printing more and more money (QE) are likely to increase inflation to dangerous levels over the next few years and we all need to be on the ball!!!