Think of your interest rate as an insurance premium for your cash…just don’t over insure
Having worked in financial services for a few months now, one of the most common situations I’ve seen is clients keeping more cash in their bank than they really need to.
One of my biggest beliefs about your finances is that nobody can argue with how you feel.
But as a financial professional, I can do my best to educate somebody which could change their feelings about their money.
I’ve written before about how the interest rate on your savings could cost you money.
But I want to approach this from a different angle to demonstrate the main benefit holding cash in your bank gives you.
Cash in the bank gives you a guarantee that you’ll get that cash back whenever you need it.
If you put that cash anywhere else – investments, property, other assets – that guarantee does not exist. It’s not even guaranteed under the mattress (what if you get robbed?)
However, the ‘price’ you pay for that is the reduction in the ‘real time’ value of that cash.
This involves applying two figures to your cash:
1) Your interest rate
2) The rate of inflation
It’s generally correct to assume that the rate of inflation is higher than the interest rate on your cash. And this is especially true right now.
£1000 in the bank gets an interest rate of 0.2%
£1000 is subject to an inflation rate of 2.5%
A year later I need to get that cash out of my bank account.
£1000 is now worth £1002
£1000 needs to be worth £1025 in real time to keep up with inflation of 2.5%
The shortfall is the difference between £1025 and £1002. So, keeping my cash in the bank has technically cost me £23 over a year.
I like to think of this as an insurance premium.
Think about any insurance policy you have. The main reason for taking it out is peace of mind right? You hope you don’t have ever have to rely on it, but you’re happy to pay the premiums knowing that you’re covered should the worst happen.
And it’s a similar feeling for keeping cash in the bank.
In terms of its real time value, holding cash costs you a little bit of money.
That bit of money is essentially the premium you’d pay to your insurance provider.
In return, you get the guarantee that if you need to get back the cash you put in your bank, you can access it at any time. There is no risk involved in that sense. It’s protected.
Contrast this to putting your money elsewhere – property, investments, other assets – you take on the risk of losing your money but also the potential of making money. But you lose any guarantee that your initial sum of money is protected.
Keeping too much cash in the bank is like insuring yourself for something you don’t need
Let’s go back to our insurance comparison.
Over insuring means paying more to insure something that I won’t need to ever claim for.
If I only ever go on holiday in Europe, but I take out Worldwide insurance cover, my premiums will cost more even though I don’t need that much cover.
It’s the same with cash in your bank. The real time value you lose by holding cash in the bank should be limited to the amount of cash you will need to access at any point.
Keeping more cash in the bank than you will need to spend is like paying for unnecessary insurance.
So, when somebody says they feel safe having their cash in the bank, I’m not going to argue with that.
It’s sensible for all of us to have a certain amount of cash we can easily access.
But I will question if somebody is keeping too much cash in the bank after assessing their spending needs.
If too much cash is in the bank, it’s wise to think about better places to put that cash that will actually help it grow in value. It’s likely you’ll be able to take a bit more risk with that bit of cash because you have time on your side. That’s where investing your cash, as opposed to saving it, becomes a vital financial strategy.
But for now, look at what’s sat in your bank account. Then think about, realistically, how much of that you would need to access in the next few years.
As a rule of thumb, 3 months of household bills and essential expenses is a starting point. Then add any one-off costs in the next few years – holidays, events. Then factor in additional savings based on future income.
If you have any money left, it’s money you don’t need that absolute guarantee on. And therefore, money you don’t need to let reduce in real time value.
Money is more than just figures and calculations. Money evokes strong feelings. Keeping cash in the bank can provide a feeling of reassurance for many of us. And it may stem from previous negative experiences with our money.
I’m all for keeping cash and accepting that you will lose a small bit of value in exchange for peace of mind.
Just make sure you’re not ringfencing unnecessary money as cash because you may turn the benefit of a guarantee into something more risky.