What does inflation mean for savings?
What does inflation mean for savings?
Inflation rates are often in the news – going up or down, a sign of good times or bad for the economy. But what do these changes mean for you, and how will they affect your savings? Let’s take a look…
What is inflation?
Inflation is the way money starts to buy less over time – or you can look at it as everything starting to cost more.
Thirty years ago, penny sweets really cost a penny and a round of drinks was less than £5. Times change, and money changes with them.
Inflation goes up and down, depending on how quickly money changes in value. If inflation is at 1%, something that cost £100 one year will cost £101 the next. If it’s at 4%, that £100 product will cost £104 the next year.
How is inflation calculated?
Inflation is calculated by looking at what’s going on in the real world. A key method is called the Consumer Price Index (CPI) – done by checking the cost of a loaf of bread compared to what it cost a year ago, and doing the same for hundreds of other common products to get an overall view of how prices have changed.
The items that make up the CPI are collectively referred to as the consumer price inflation basket of goods and services. It’s designed to reflect what we as a nation are regularly spending our money on. What's in the basket is reviewed every year and things are added or removed to make sure that what’s being measured still reflects patterns of consumer spending.
Another method is the Retail Price Index (RPI), which also looks at housing costs.
Why do inflation rates change?
Inflation tends to fluctuate, depending on whether people feel like spending their money. If everyone is spending, inflation tends to go up. If everyone’s saving, inflation tends to go down. Economic theories differ, but some believe that moderate inflation is good for the economy.
The Bank of England tries to keep inflation around 2% - this is the inflation target set by the Government. If inflation goes too high, the Bank of England will often increase interest rates to encourage people to save. If inflation is too low, it will lower rates instead to encourage people to spend.
What does inflation mean for your savings?
Say you put £100 aside. A year later, if inflation is going up, that money can’t buy quite as much as it used to. But hopefully, if you put that money in the right kind of bank account, you earned some interest over the course of the year. The question is, have you lost or gained overall?
If inflation is at 1%, but you earned 2% interest, that’s great – you came out on top. If inflation is at 2% and you only earned 1% interest, you made a loss in real terms over the year as your money will buy you less than at the start of the year.
The key point is that if you want your money to grow, make sure the interest rate you get is higher than the rate of inflation.
How can you get an interest rate that keeps up with inflation?
When the economy is in a downturn, it can be hard to get good interest rates for your savings. Inflation is often low – but so are interest rates – making it hard but not impossible to stay ahead of inflation. Here are a few options you should look into:
- fixed rate savings account – also called fixed term deposits or fixed rate savings bonds, these accounts lock your money away, usually for 1 to 5 years. In exchange, you get a higher rate of interest than a typical savings account, set for the length of the term
- cash ISA – these are a great option if you’re looking to minimise the tax you pay. Any interest you earn on your ISA is tax-free. You can only pay in up to your ISA limit each year – a maximum of £20,000 in 2018/19
- fixed rate ISA – combining the tax benefits of an ISA with the features of a fixed rate savings account, fixed rate ISAs lock your money away for a set term and generally offer a better rate of interest than a cash ISA
- lifetime ISA a special type of ISA designed to help you save for retirement or to buy your first home (you can’t compare this type of ISA with us). You can pay in up to £4,000 a year, and the Government will add an extra 25% – so you get up to £1,000 of free money. The downside is that you can only take the money when you buy your first home or when you retire at 60+, otherwise you lose all your bonuses
But remember, if you get an offer out of the blue via a call, email, post or word of mouth that sounds too good to be true in terms of potential inflation-beating returns, it could be a scam, so be very wary.
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