Current Accounts = Mediocre Returns

At its heart, an interest rate is the price of money. A 5% interest rate means that borrowing money for a year will cost you 5%. And lending money for one year will earn you 5%.

Savers hate low interest rates, for obvious reasons. With low rates, they’re making a poor return on their investments. On the other hand, borrowers love low rates, as the cost of servicing their debt is lower.

But it’s not just the headline interest rate which matters. We also need to consider inflation.

Real Interest Rates

A nominal interest rate is just the standard figure quoted by a bank - for example on your current account or for a mortgage. But we’d be better off adjusting for inflation. This adjustment gives you a real interest rate – simply the nominal interest rate minus the rate of inflation.

For example, if the nominal interest rate is 5%, and inflation is 2%, you have a positive real interest rate of 3% (5% - 2% = 3%). And if the nominal interest rate is at 5% and inflation is running at 10%, you’d have a negative real interest rate of 5% (5% - 10% = -5%).

Real interest rates matter because they show you the price of money after adjusting for inflation. A 5% nominal interest rate may seem high at first glance, but if inflation is at 10%, it looks very different.

As a saver, negative real interest rates mean your money is growing slower than inflation – i.e., the price of goods and services in the economy is rising faster than your savings.

As a borrower, however, negative real interest rates are a benefit. They mean that the value of your debt, after adjusting for inflation, is decreasing.

In recent years, savings rates on current accounts have finally increased above 0%. But on a real interest rate basis, savers are actually worse off than they were before COVID. Why? Because inflation has gone through the roof.

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Before the 2008 Financial Crisis, savers could rely on positive real interest rates.

Back then, individuals could deposit their savings into a current account, where they would earn a respectable 4-6% interest per year. With inflation averaging 2% during this period, the process was clear – if you saved money, its value increased faster than the rate of inflation. Holding your savings in a current account wasn’t optimal, but it was enough to get by.

After 2008, however, the economic system underwent a radical transformation. As credit markets dried up and confidence in the global economy plummeted, central banks around the world lowered interest rates to encourage borrowing and stimulate the economy. Given the severity of the crisis we had, you can understand why. But these interest rates remained very low across most economies in the world for over a decade. And this structural change of negative interest rates has, in turn, harmed savers.

In an ideal world, inflation would be low and stable. And interest rates would be relatively low. Having neutral or slightly positive real interest rates would strike a fair balance between rewarding savers and not punishing borrowers.

But with so much debt among governments, corporations and households, central banks have promoted negative real interest rates for the past 15 years, trying to erode the inflation-adjusted value of that debt. However, that has encouraged even more borrowing, and punished savers. Not very smart!

In a normal world, when inflation runs hot, interest rates rise. This makes borrowing for individuals, companies and governments more expensive, and dampens inflation.

But when inflation spiked after COVID, interest rates didn’t rise and so inflation continued to run. Eventually, when central banks decided to raise interest rates, inflation had got so out of hand that rates had to go higher and stay there longer

than would otherwise have been the case.

The result? Real interest rates became even more negative than they were before COVID. Who does that hurt? The savers! At the expense of companies and government which have over-borrowed. And to support all that debt, it’s likely that real interest rates will largely remain negative for many years to come. This is destructive for the normal saver, whose savings are eroded by inflation.

It can be incredibly damaging to hold life savings in current accounts for long periods. Under negative real interest rates, your current account savings are being eroded by inflation each year.

This is what happens:

Current Account at 2%

If you take £1,000 and put it into your current account at a 2% interest rate, then after thirty years you’ll have £1,811. Seems ok – that’s nearly doubling your money.

However, what if you adjust for inflation at 4%?

Current Account at 2% vs inflation at 4%

Taking the same £1,000 at the same 2% interest rate over the same thirty year period, but adjusting for a 4% inflation rate, you’ll end up with £545.

Suddenly the 2% interest rate seems terrible – rather than doubling your money, you see that – adjusted for inflation – its value has fallen by nearly 50%. Negative real interest rates kill long-term savings.

Investing at 7% vs inflation at 4%

So how can you do better? By investing in equities, you can expect a long-run return of around 7% per year. When adjusted for inflation, that’s a 3% positive real interest rate.

After 30 years, your initial £1,000 will be worth over £2,400, after adjusting for inflation.

Compared to your current account at a 2% negative real interest rate, you’ll have over four times as much.

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You Can Do Better!

In the old world of positive real interest rates, a decent salary and strong savings would guarantee a comfortable life.

But with wage growth so low, property costs so high, and cash in the bank facing a below-inflation return, you need to do better with your savings than putting them in a current account. That’s why investing is so important. Those small extra returns, compounded over time, will have an enormous impact down the line. So don’t be lured in by a measly 2% return on your current account – you can do much better!

What about if you need the money in the short-term, and don’t want to risk a market crash? Then pick a lower risk portfolio or, at the bare minimum, find the highest current account rate you can.

Remember – for your long-term savings, your current account will only achieve one thing. That’s a below inflation return. But by building your long-term savings in an investment account, you’ll turbocharge your asset base. It's an easy win.