Choosing a savings account need not be a headache
April is an anxious time for banks and building societies. This is also when millions of savers in the UK shop around for a good ISA (Individual Savings Account) before the start of the next fiscal year to shelter their savings from the taxman. We are inundated with advertisements on the best saving accounts ever single day in the media and bombarded with jagons like AER, tracker, fixed and variable rates.
For most of us, it's still quite a bit to take it. I've listed some of the terms used in savings and what they actually mean. Please bear with me here for some of the terms below can be rather basic for those in the know. Please feel free to add to the list in the comments section if I'm missing any.
The main point of keeping your money in the bank (or building society for that matter) is simply because they'll be safer there compared to under your pillow. It's a win-win situation between you and the bank - your money is safe and you have reasonable access to it, the bank can use your money to earn more money through investments and lending to others.
As a bonus, your bank pays you part of the profit that it makes, usually through interest payments. This payments can be made either on a monthly, quarterly or annually basis.
Interest rates are often quoted in AER while gross and net rates are sometimes included in the description.
This refers to Annual Equivalent Rate. It assumes that interest would be added to the original sum and then compounded for a year. In other words, if your account pays interest monthly, AER's calculation will add first month's interest into the original sum before calculating the second month's interest and so on. Due to this, AER is the actual interest before tax (more on that later) that you will get.
This is the rate that you will be paid each term, annualised. For instance, if the annual gross rate for a savings account that pays you a monthly interest rate is 12%, you essentially gets paid 1% interest per month. If an account with quarterly interest is paying 2% per annum, you'll get paid 0.5% per quarter. It doesn't take interest compounding into account.
That said, for those accounts paying out interest annually, AER = Gross rate. Like AER, gross rate doesn't take taxes into account too. Regardless, using the AER rate for comparing which accounts is more appropriate.
This is net of tax that is currently at 20% (for basic rate taxpayer) or 40% (for high rate taxpayer) and it is deducted at source. That is unless your income is lower than the individual tax free allowance (£8,105 for those under 65 for fiscal year 2012/2013)
The agreed rate for a specified term. It's usually used together with one of the above described rate. For instance, a "AER of 2%, fixed for 18 months" means that an AER of 2% is agreed upon between you and the bank for a period of 18 months.
In return for a higher interest rate, there is usually a penalty if you wish to draw out the money in advance from fixed rate saving accounts, typically some or all interest will have to be forfeited.
For those who can afford to lock up some cash over a period, you can consider setting up a fixed rate bond instead. In return for higher interest, your money is locked in for a specified period of time.
As opposed to a savings account that offers fixed rates, most savings accounts offer variable rates depending on the competitiveness of the bank you are with. While the bank can unilaterally change the interest rate, your money is not locked in for a fixed period of time
There is some confusion between tracker and variable accounts. Unlike a variable account that derives its interest rate through the banks' algorithm, a tracker account's interest tracks an index or some benchmark.
For instance, an account that tracks Bank of England's (BOE) base rate (currently at an all time low of 0.5%) can offer 2% plus BOE's rate - that is a total of 2.5%. This is usually for a fixed period of time. Should BOE's rate increases to 1% within this period, you'll get 3% (2% + 1%) instead.
Why is this craze over interest rates? Well, to beat the inflation of course! When I arrived in London in the summer of 2007, a pint of organic whole milk was going for 45p. The same pint is now going for 58p. That's a whopping 4.2% increase annually. In other words, if that inflation rate is applied to an item that cost £10 today, it'll be £10.42 next year and £10.86 the next.
That is the reason behind the obsession behind looking for an interest rate "that will beat inflation". As long as the interest rates (after tax) beats inflation rate, you'll be better off. Else, your money will just worth lesser by the day.
Huh? Lesser by the day? Surely not? Well, the nominal value of your money remain the same. If you have placed your £100 into an account that pays no interest for a year, you will still have that £100 at the end of the day. That £100 is your "nominal" value.
That's not the end of the story. We have discussed about inflation. What we are really concern about is the "real" value of your money. If inflation is 4% per year, your £100 would be worth around £96 by the end of next year. £96 would be the "real" value even if the "nominal" value remains as £100.
On the same note, if you have placed that £100 into a savings account that gives you 1%, you will still lose 3% of its real value after a 4% inflation. Now you know why there are folks out on strike even though they are given a pay raise - the raise just isn't enough to overcome inflation. As a result, their real salaries are shrinking.
Consumer Price Index
How do we measure inflation? We do it by tracking how everyday items cost. Consumer Price Index (CPI) measures the price increases (or decreases) of a pre-selected basket of 600 items on a monthly basis.
The Bank of England sets itself a target of 2% for CPI and its Governor has to write an open letter to the Chancellor if it deviates by more than 1% from this target.
Retail Price Index
Retail Price Index (RPI) used to be the official inflation index before CPI replaces it. Unlike CPI, it includes costs of housing (council tax, mortgage interest payments etc.).
Being the other thing that is certain in life, we are obsessed about the taxes we pay. Few things irks us more than having our interests whittled away by inflation and taxes. If it helps, taxes for savings accounts are deducted at source so you probably don't feel it that much.
Interest income tax rate depends on whether you are a basic or high rate taxpayer. If your income is between £2,710 and £34,370 per year, your interest will be taxed at 20%. If your income is between £34,370 and £150,000, it'll be 40%. If you earn more than £150,000, it'll be 50%.
The good news is that each of us can avoid paying tax on interest income by opening up an ISA (Individual Savings Account). For the new fiscal year (2013/2014) we can put away £5,760 in a cash ISA without having to pay any taxes. That amount can be be rolled over to another ISA account when the personal allowance is renewed.
Again, the same terms used for a normal savings rate applies to a cash ISA. Some ISA accounts offer fixed rate interest for a more than a year when your money is locked in while others offer a fixed rate interest for a year and then revert to a much lower rate after that.
Here are some terms that you'd come across when deciding which savings accounts that you should squirrel your cash. What else do you look at when choosing a savings account?
Friday, March 22, 2013
Savings Jargon in the UK