How to save money in the bank - with compound interest
Wednesday 8th June 2022
What's it all about?
This guide is designed to help you understand:
Putting your money in the right places
The importance of instant access savings
Mid-to-long term saving options
What if we told you that by putting your money in different places, you could actually make even more of it?
Putting your money in the right place
The main thing to keep in mind when saving money is, when you might need it. Different saving accounts can take different amounts of time to withdraw from. If you need your money right now but can’t access it for a couple of weeks, you might run into trouble.
Before we talk about saving, it’s important to try and clear any high-interest debts you may have. Credit cards and payday loans often have high-interest rates that can counteract all the good work you do on the savings front. If debt is left to build up, it can often become more difficult to keep up with the payments.
Although 2020 saw an all-time high in the average household’s savings ratio, the latest results from the Office of National Statistics have shown a significant drop. With the UK collectively saving less, the importance of putting your money in the right place is as significant as ever.
A good way to think about savings is a tower of champagne glasses. You pour your money into the top glass until it is full before it begins to spill onto the other layers. In money terms, the top layer should be built for short term goals and unforeseen circumstances - just like if your car breaks down. Once you have enough to act as a safety blanket, you can move on to longer-term goals as you know you’ve got enough if a big bill comes your way.
Otherwise known as Easy Access accounts, these accounts are great for stashing away money for the short term. As you can usually withdraw from these accounts at a moment's notice and without charge, they come in handy in unexpected circumstances. Broken boiler? Simply transfer the money over to avoid using your credit card. Now we know that building up a safety blanket isn’t easy for some. A 2020 survey by Shelter and YouGov showed that nearly 40% of UK households are a single paycheque away from homelessness. Try your best to put away whatever you can into Instant Access savings. This way you can reduce the impact of unexpected bills. If you ever find yourself dipping into these savings, you may want to build your funds back up to the previous amount to provide some much-needed security.
Although instant access savings are great for withdrawing money easily, they do come with some downfalls. If the rate of inflation is higher than the rate of interest, your money will lose some of its spending power the longer you leave it there. Let’s say you had £1,000 saved and inflation was higher than interest rates by 3%. If this was true for a year, your money would be worth £30 less. This is where mid-term saving methods come in handy.
Financial advisors often define mid-term goals as an upcoming expense that will take place between three to ten years from now. This could be a new car, a wedding, a dream holiday or even a first home deposit. If saving for your first home, a Lifetime ISA (or LISA) could be right for you. You can deposit up to a maximum of £4,000 a year with a government boost of 25%. If you deposit the maximum amount in a financial year, you’d end up with £5,000 in total. Even better - any returns that you make from interest are completely tax-free. However, if you were to withdraw for any other reason than buying your first home, retirement or terminal illness you would lose the government boost. If you already own a home or aren’t looking to buy just yet, bonds are often seen as a good option by financial advisors. We’ll go over two types: Fixed-Term Bonds and Government Bonds. Fixed-term bonds, otherwise known as a fixed-rate savings account, works by locking your money away for a set amount of time and paying you a set interest rate for that time. Depending on the bank, you can either choose how long you lock your money away for or they may choose set intervals.
The perks of these accounts are that the interest rates are often higher than instant access savings and because the interest rate is fixed, you’ll know exactly how much you will earn. However, as the accounts are designed to be fixed-term, you may have to pay a penalty fee if you need to access your money before the agreed time. For this reason, it’s important to only put away money that you know you won’t need for that time. Government bonds, known as gilts in the UK differ slightly from fixed-term bonds. In the case of gilts, your money is loaned to the government in exchange for interest. Governments will often use these loans to finance projects such as infrastructure outside of the taxes they raise. Once your money is given to a government, you will be given a coupon that will pay you a set level of interest at regular intervals. Once the bond reaches its maturity date, your original sum of money known as the principal will be returned to you. For instance, if you invested £5,000 into a 5-year gilt with an annual interest rate of 5%, you’d receive £250 a year for 5 years before receiving your initial £5,000 back. Different bonds have different maturity dates so it’s important to pick an amount of time that you will not require the money back. Although all investments carry some element of risk, established economies are seen as low-risk when compared to other countries. In the case that you did need to get some money back, you can sell your bond on the open market but as with all investments, you can lose money as well as make it.
Long-term goals are anything that you wish to achieve over 10 years from now. The main examples are helping your kids out or retirement. Now, there’s a reason that we’ve not mentioned compound interest so far. This is because it often takes over 10 years to see any notable difference. Put simply, compound interest is when you earn interest on the money that you’ve saved AND on the interest that you’ve earned. Imagine compound interest as a snowball rolling down a hill. As it collects more snow or interest in this case, the snowball will gradually grow in size. The longer you leave it to collect interest, the bigger your savings will grow. To calculate how long it will take to double your money you can use the Rule of 72. Simply divide 72 by the interest rate. If interest rates are 2% on average, it would take 36 years to double your savings if left untouched. However, in recent years the interest rates of banks have been significantly lower than this - meaning that it would take more than a lifetime to double your savings.
Investing in the stock market is often suggested as an alternative for the mid-to-long term. Stock-market investments tend to do better than cash if left long enough to ride out any highs and lows of the market. Typically speaking, this is said to be a minimum of 5 years. Now that is not to say that stocks come without risk. There is a possibility that you could lose the entirety of your investment as well as make a large profit. There are certain types of investing that are said to reduce this element of risk. By spreading your money across a number of markets and industries, something known as diversification, you can reduce the likelihood of your entire investment losing its value. It’s really important that we stress the importance of never investing money that you simply cannot afford to lose. If you do choose to invest, make sure you do it responsibly. And remember, these are just a few of the options available to you. Certain methods of saving are suited for both personal and financial circumstances. So if ever in doubt, speak to a financial advisor.