This quick hack tells you if your interest rate is costing you money
Updated: 2 days ago
Interest rates are low right now. Historically low. And that’s potentially really bad for money that you keep in your bank account or a separate savings account like an ISA.
Interest rates are influenced by something called the ‘Bank Rate’. It’s controlled by the Bank of England and is commonly referred to as the ‘Bank of England base rate’.
Sitting within the BoE (Bank of England) is a group called the Monetary Policy Committee, made up of a panel of senior experts that vote on what the ‘Bank Rate’ should be. This vote happens once a month.
It’s widely reported in the media, so you’ve probably heard headlines like ‘the Bank of England has voted to keep the base rate at xxx%’.
Let’s quickly recap on the basics of interest rates. Skip through this if I’m teaching you to suck eggs.
How does the Bank Rate affect my money?
The Bank Rate effectively influences the interest rates that banks and building societies apply to things like mortgages and savings.
Think of it like a ‘pass it on’ effect. Right at the top the BoE sets the monthly Bank Rate. Financial institutions then ‘base’ their interest rates on that Bank Rate which gets passed on to the customers – individuals or businesses - who have money in those institutions.
With a low Bank Rate, you can expect low interest rates from your bank.
- If you’ve got a mortgage, a low interest rate is beneficial. It means your mortgage repayments will be subject to lower interest rates, so you’ll pay less.
- If you’ve got savings, a low interest rate isn’t great for earning money on your money.
£1000 sat in your bank account at an interest rate of 3% = £30 of interest earned a year. After a year, you’d have £1030.
£1000 sat in your account at 0.1% = £1 of interest earned a year. After a year, you’d have £1001.
So as long as interest rates are above 0%, my money is still growing?
In theory, yes. Though the reality is a bit more complicated. But stay with me on this.
Inflation is a key piece of the puzzle
While your money is sat in your bank account earning a certain amount of interest, something called inflation impacts what certain things cost to buy.
Inflation measures the rise in price of everyday things we buy – e.g. food, smartphones, petrol, clothes – and is reflected as a percentage.
Like the Bank Rate, inflation is reported on a monthly basis.
Currently, inflation is pretty low. Just 0.7%. This means that prices have risen, on average, by 0.7% compared to a year ago.
Inflation rate vs Interest rate
While we’re pretty aware that interest rates on our savings are dire at the moment, we may not realise that the interest rate is actually causing us to be worse off. And that’s where inflation comes in.
If the inflation rate is higher than the interest rate of the account your money is in, you’re probably going to lose money.
Now inflation is not an exact science – your spending might be heavy on certain things that have not increased so much in price. Think of this as your ‘personal’ rate of inflation.
Finding ways of reducing your outgoings can also offset any inflation rises.
But as a benchmark to see if your money is growing at all, the official inflation rate is a useful one to know.
A quick hack to check if your interest rate is costing you money
Take your interest rate and subtract the inflation rate.
If the answer is a minus figure, then you’re losing money.
In other words, the money you earn on your savings from interest will be lower than the extra money you need to pay for things as they go up in price.
Interest rate = 0.5%
Inflation rate = 0.7%
0.5 – 0.7 = -0.2
The result is a negative figure. In the red. It effectively means your ‘real’ interest rate is -0.2
So £1000 at -0.2% would technically give you back just £998 in a years’ time.
As we know, interest rates are really low at the moment. The current Bank Rate is just 0.1%, with talk of it potentially going to 0%, or even negative figures.
This has meant getting a decent interest rate on your savings has become next to impossible, let alone an interest rate that can beat inflation.
Bear in mind that inflation is never guaranteed – the rate of inflation tends to vary slightly month-to-month. But with that is the possibility of the Bank Rate varying too.
How can I make sure my interest rate beats inflation?
Depending on your financial situation, it might not be possible to beat inflation with the interest rate on your cash. Follow these steps to give yourself the best chance of protecting your money from rising costs.
1) Review where you’re keeping your money at the moment
So many of us have cash we’re not using just sat in our main bank account.
That is costing you money. The interest rates on current accounts won’t be much higher than the Bank Rate. Which we know is lower than inflation.
2) Work out when you’re likely to need your money
The sooner you need to get hold of your cash, the greater protection you’ll need on it.
The safest place for money you need tomorrow is in a current or savings account.
Why? Because your money is protected, by law, if the provider of that account went bust. So in terms of peace of mind and security, it’s risk-free.
That said, keeping your money under the bed is still widely done too. But not without risk.
It can be hard to know when you might need access to cash. A starting point is to create an emergency fund and work out other one-off expenses that you’re likely to have in the next year or so, for example, a new car, house deposit, or life event like a wedding or holiday.
3) Look for the best interest rates for instant access accounts
An instant access account could be a current account, savings account or cash ISA.
Have your inflation figure in mind. That’s the rate you ideally want to beat to make sure that your instant-access cash is earning something.
Best for large lump sums
It’s really a case of best of the worst right now.
Marcus Online Savings account currently pays 0.5% interest for balances up to £250,000.
What does this mean? Keeping big money in easy-access accounts is simply for peace of mind at the moment. It’s not a way to earn any interest.
Best for small lump sums
If you have a lump sum under £1000, then Virgin Money pays 2.02% on balances up to £1000.
Best for small regular ‘drip feeding’
A regular saver allows you to build up savings month-by-month. But are limited in terms of how much you can pay in. That said, they often pay better interest rates.
Natwest currently pays 3.04% on up to £50 saved a month
4) Make better use of cash that you don’t need easy access to
Pay off high-interest debt
Remember that thing I was talking about earlier – your ‘personal’ rate of inflation.
Well this takes into consideration any debts you have. The higher those debts, and the higher the interest on those debts, means they’re going to cost you more to pay back.
So if you have cash that you don’t need in the near future, paying off things like credit card debt, or making extra repayments on your mortgage could reduce the overall amount those things cost you.
Get a better interest rate to lock away money for a certain amount of time
Once you’ve worked out how much money you’ll need access to within the next 12 months, you might want to consider putting any additional cash into a fixed-rate account.
A fixed-rate account guarantees you an interest rate for set amount of time. Your money is ‘locked in’ for the timeframe, meaning you can’t access it.
And the longer you lock it away with the bank, the better the interest rate they’ll give you. And in many cases, that interest rate will beat inflation.
In terms of maximising returns, it’s impossible to say if the interest will be the rest rate on the market throughout the fixed time period. Interest rates in general could go up or go down. So that fixed rate could potentially beat the market or be beaten by it.
It’s impossible to say at the time of opening an account, which is why most people choose fixed-rate accounts for the security and peace of mind of a guaranteed interest rate.
Don’t assume that just because your cash is sat in a bank account earning a tiny amount of interest, that it’s still earning something.
Next time you’re looking at interest rates on your money, use the interest rate minus inflation rate calculation to see if your interest rate is actually costing you money.