Following the financial crash of 2008, the Bank of England (BoE) reduced the base rate – on which all other interest rates are pegged – to a record low of 0.5% in a bid to stimulate growth by making borrowing cheaper. Four years on, the rate remains the same.
New BoE chief Mark Carney has indicated he won’t raise the base rate until unemployment goes below 7%, currently at 7.8%. But with the UK economy finally showing the first signs of a sustained recovery – the ‘green shoots’ optimistically talked up too soon – it’s only a matter of time before the Bank does raise the rate, and interest rates along with it.
The question is: what does this mean for you?
Save or invest?
In recent years, savers have been hit by a combination of low interest rates and relatively high inflation. With ‘market leading’ fixed rate bonds at 2.55% (at the time of writing) but inflation last measured at 2.9% for June 2013, people are watching their nest eggs depreciate steadily in value. As The Economist put it in April: “The key point is not that nominal interest rates are low. It is that…real (after-inflation) interest rates are negative – money stashed in a bank buys less when it comes out than it could when it went in.”
With the timing of the base rate increase uncertain, what should savers do with their cash now? The best interest rates are found in fixed rate bonds and ISAs, but this could lock you into relatively low returns once rates do rise. Equally, more flexible alternatives could leave you with miserable yield for longer than expected – there’s no telling when unemployment will dip below that magic 7%.
Most people are too cautious to approach investment, but it’s the only realistic way of retaining the value of capital in a low-interest environment, and offers more flexibility than fixed rate savings options do. And there are options for the cautious. Plenty of mutual funds are targeted to this demographic, mixing investments in relatively stable companies with index-linked government bonds, money markets, market indices and other low-risk securities. The returns are modest in investment terms, but comparatively stable, and will almost certainly still beat savings bonds while interest rates remain depressed.
And with markets currently on an upswing, now could be the perfect time to get in while shares are low, ready to benefit from growing market confidence as the economy recovers.
Is property the key?
The traditional route for British savers is to plough their money into tangible assets – chiefly property. Low interest rates have made it an excellent time to take out a mortgage if you can get the deposit together, and with house prices rising again, now is a good time to buy from an investment point of view.
However, the prospect of higher interest rates should make prospective homeowners think twice before putting down their deposit. Comparatively low house prices need to be offset against the cost of servicing the debt as rates increase. If we learnt anything from the sub-prime crisis, it’s to not take on debt you can’t afford.
There are worries that currently low interest rates mixed with increasing consumer confidence will lead to another housing bubble, and consumers will take on more debt than they can afford in the future. As revealed in a July 2013 Resolution Foundation report, should the base rate reach 2% in 2017, 800,000 UK citizens will be spending half their income servicing their debt; particularly if they have an ‘interest only’ mortgage.
The real prize at the moment is a fixed rate mortgage – locked in at ultra-low interest for 2-5 years and beating the upsurge in house prices. But even then buyers are advised to tread carefully and realistically consider what their finances will look like once the fixed rate ends.
Where to put your money
So if you’ve got money lying around, where should you put it? Savings accounts of all stripes – even market leaders – are delivering negative value. Investment is riskier, and the cost of paying a mortgage can only rise from here.
The answer, as ever, is to be smart about it. If you have enough money to spread – diversify in investment parlance – then do. Investment can be relatively low risk and still deliver better returns than saving: lower risk index funds regularly out-perform higher risk, actively managed funds. And a house will always be a good investment, at least as a home, as long as you can realistically afford it.
Just be clever about how much debt you can realistically service, and how much risk you can afford to take. Don’t be taken in by low interest rates. They may be around for a while yet, but they won’t last forever.